Low Interest Rates
May Be the New Norm
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
February 7, 2005; Page A2
Long-term interest rates in the U.S. are unusually low. They may be here to stay.
Despite widespread expectations on Wall Street that bond yields are bound to
rise, some economists -- including some at the Federal Reserve -- argue that
today's low yields aren't abnormal. Such yields reflect the economic reality that
inflation is low and expected to remain low, and that the world is awash in
savings.
If so, prices for stocks and homes are less at risk of plunging and record U.S.
budget and trade deficits are less of a worry. But savers face a future of skimpy
returns on stocks, bonds and other investments and President Bush's private
Social Security accounts could well be a tougher sell.
On Friday, a less-robust-than-expected employment report sent the 10-year
Treasury bond yield plunging to a little over 4%. That is where it stood a year ago
despite subsequent economic developments that ordinarily would push yields up:
The U.S. economy has strengthened, fear of deflation has evaporated, the Fed
has raised short-term interest rates six times, and U.S. budget and trade deficits
have widened.
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Wall Street's overwhelming consensus is that current low rates can't last. All 45
economists polled by Blue Chip Financial Forecasts expect yields to be higher a
year from now. The average forecast is 5.2%, almost identical to the -- inaccurate
-- forecast the economists made a year ago. Wall Street experts cite temporary
factors for the low level of rates today: increased demand for long-term bonds by
underfunded pension plans and reduced supply from the mortgage market;
leveraged investments by hedge funds borrowing at even lower short-term rates,
and purchases by Asian central banks aimed at propping the dollar up against
their currencies to protect exports.
Long-term interest rates are the sum of two components
that compensate an investor for lending money long-term:
expected inflation and some "real" rate of interest. The first
reflects the expected loss of purchasing power from
inflation. The second part reflects a variety of risks: that
inflation turns out higher than expected, that the value of an
investment fluctuates violently, that another asset such as
stocks delivers a better return.
Inflation, excluding food and energy, has fluctuated between
2% and 2.5% since 1997 -- except when a brief dip toward
1% in 2003 aroused deflation worries. Yields on inflationprotected Treasurys suggest investors expect inflation to
stay in that range for the next decade. Thus, the recent drop in long-term rates
isn't because of lower inflation, but instead reflects a decline in real rates.
In the late 1990s, the real rate was between 3% and 4%. Today, it is about 1.7%.
Why do lenders demand less real return now? Some Fed officials believe it is
because inflation is not only low, but expected to remain low for many years.
They note that in previous periods of low and stable inflation, long-term rates
were around current levels. Indeed, bond yields and underlying inflation now are
right on their average since 1831 according to data supplied by the Bank Credit
Analyst, a forecast journal. It is the high real rates of the 1980s and early 1990s
that are anomalous.
Typically, long-term rates are higher than short-term rates mainly because
lenders can't be sure inflation will be the same in the future as it is today. But if
lenders are confident inflation will be stable, they demand less of a premium for
lending money for long periods. Brian Sack, senior economist at Macroeconomic
Advisers and a former Fed staffer, says, "The inflation-risk premium has
fallen...considerably over the past two decades as inflation has declined and
become more stable."
The Fed also has helped drive down real rates by talking more candidly about its
plans for short-term interest rates. "The Fed's new policy of 'transparency' has
taken the shock value out of monetary policy," writes economist Ethan Harris , of
Lehman Brothers, in a report. That, he says, makes markets less volatile and
investors more willing to buy longer-term, riskier assets.
Under this view, low rates for the long run are good news: They mean that house
prices can remain buoyant and that today's stock valuations are more
sustainable. They could also "trigger a prolonged investment cycle," says Joseph
Carson, an economist at Alliance Capital Management, as U.S. companies profit
from high sales growth and inexpensive capital. He notes that long-term rates
fluctuated between 2.5% and 4.5% from the mid-1950s to the early 1960s, when
growth was strong, because inflation was low and stable.
But there is a darker interpretation: That low yields suggest prospects for profits
on investments are skimpy everywhere, including on stocks. Treasurys, the
world's safest investment, are the benchmark for returns on assets from stocks to
real estate. Corporations that once splurged on money-losing dot-com projects
now hoard cash, repurchase their shares or boost dividends. Capital spending
since 2003 has persistently fallen short of cash flow, for the first time in 40 years,
a pattern that holds across "almost every sector across almost every region of
the world," says Vadim Zlotnikov, a strategist at Sanford C. Bernstein & Co. "We
have collectively lost our ability to dream."
The gargantuan U.S. current-account deficit (the shortfall on all trade and
investment income with the rest of the world) is a symptom not just of inadequate
saving in the U.S., but excessive saving overseas. Bond yields are below 5% in
every big developed country except Australia. They are 3.5% in the euro zone
and 1.3% in Japan, though their budget deficits rival that of the U.S. Latin
America and OPEC have joined Asia and Europe in running current-account
surpluses, notes Martin Barnes, editor of the Bank Credit Analyst. Asian central
banks are buying Treasurys in part to recycle domestic savings that have no
other outlet: China's personal-saving rate is 40%, compared with the U.S.'s 1%.
"You just have a lot of capital out there, and a lot of that will end up in the U.S.
bond market," says Mr. Barnes.
Perhaps these are all temporary factors. Mr. Zlotnikov says the resurgence of
mergers and acquisitions may mean companies are rediscovering their animal
spirits. As hedge funds and Asian central banks lose their taste for Treasurys,
yields could rise to previous norms. Mr. Sack says 4% yields can't be justified if
the Fed raises short-term rates to 4%, from 2.5% now, as he expects. The lower
dollar and slower productivity growth may push inflation higher forcing the Fed to
raise rates more rapidly.
But if yields stay low, Mr. Bush's personal Social Security accounts face a
significant obstacle. As proposed, a worker who chooses a private account must
expect a return of more than 3% on top of inflation to offset the reduction in
traditional government-provided Social Security benefits at retirement. That may
be a reasonable hurdle if real rates are 3%. But if they remain around 1.7%, and
stock returns are commensurately lower, many workers may opt for traditional
Social Security instead.
Write to Greg Ip at greg.ip@wsj.com