The interest rates are lowered by the Federal Reserve, in order to stimulate growth during economic decline. The borrowing costs become cheap, but what does that mean for the long run?
Interest rates are at historic lows, and right now is a great time to borrow money. This is good news, particularly for homeowners, as the burden of monthly mortgage payments is now less. It is not the first time that low-interest rates have caught public attention. Short-term interest rates are going down for a decade now, particularly since the global financial crisis. Very recently, the Covid-19 pandemic has driven the interest rates further low as most of the central banks are vowing to give economic activities a push. As per the Chairman of Federal Reserve, Jerome Powell, the rates are most likely to stay low for years to come, as the economy is trying to fight its way back from the pandemic.
The decline so far
Since the evolution of the US economy from the past decades, it is hard to miss the steady decline of the interest rates. In 1981, a 10-year treasury note was yielding an interest rate of 15 percent. Today, the yield stands at less than one percent. The critical short-term rate set by the Federal Reserve has also dropped from 16 percent to near zero. The rate of interest on 30-year mortgages has also dropped from 18 to 3 percent. This decline is huge and has implications for decision-making at both personal and public levels.
Reasons for the decline
One of the suggested primary reasons for the decline in interest rates is the drop in inflation expectations. Irving Fisher, an economist, noted a century ago that when bond investors expect high inflation, they predict less valuable dollars as their repayment, the reason why they demand a greater interest rate to compensate. When the expected inflation drops, as is the case of the past 40 years, the rates decrease as well. This is more commonly known as the Fisher effect. As per a survey of consumers conducted by the University of Michigan, the expected inflation dropped by 4.3 percentage points from 1981 to 2020, which explains a third of the decline in rates. The question now remains how inflation-adjusted interest rates, also known as the Real interest rates, have declined so much.
The Federal Reserve fixes the interest rates. It is easy and tempting to blame the Fed for this kind of decline. But how fair is it? The Fed aims to set interest rate levels at what is known as ‘the natural rate of interest’. This is the level aimed to produce employment and set stable prices. This rate, however, is not determined by the central bank but is governed by the deeper market forces such as people’s supply of savings and the demand for capital by businesses. So, when the Fed sets a low interest rate, it is more like a message, telling its people that the economy requires an equilibrium.
Theories explaining the decline of the natural rate of interest
The decline in interest rate is a collaborative result of many factors. Some of the primary driving factors in the United States that explains the reduction of interest rate includes:
Income inequality has increased over some decades now. More of the resources have shifted from poor to rich. The shift is prominent to such an extent that the rich now have a higher propensity to save, and this is why more money flows into capital markets in order to fund investments.
China has recorded rapid economic growth in recent years, and the country also offers a high saving rate. A vast pool of savings is flowing into the Chinese capital markets, and the interest rates are falling across the globe.
People’s aversion to risk has increased. This is because of the events like the Covid-19 pandemic and the financial crisis of 2008. Most people have increased their tendency of precautionary savings and now have an inclined demand for safe assets, which is also driving down the interest rates.
The average economic growth has slowed down since the 1970s. This happened because of slower technological advancements. The slow growth of technology has reduced the demand for new capital investment, which has further pushed down interest rates.
Newer technologies manifested in silicon valley are less capital-intensive as compared to the old technologies like auto factories and railroads. This shift has caused a reduced capital demand, which has lowered interest rates.
Many economists like Thomas Philippon, a New York University professor, believe that the current economy is less competitive than before. Many businesses are increasing maker power by raising prices and investing less. This again causes a reduction in the capital demand and hence puts downward pressure on the rates.
Implications of low-interest rates
The majority of the implications are self-explanatory. A balanced portfolio of stocks and bonds won’t earn as much as it did previously. Institutions like the universities, known to use the return on endowments to fund processes, will have to further tighten their belts. People will also need to rethink retirement savings. Nest eggs need to be larger by at least 19 percent for a comfortable living.
There are some pros to the declining rates as well. Young families, who are looking to buy homes, will find it considerably easy due to the low cost of mortgage financing. The government also needs to worry less in case of an increase in government debt.