Interest Rate Essay Research

Interest rates are at historic lows due to the combined effects of policy, regulation, and financial development.

Interest rates are at historic lows. The U.S. effective federal funds rate was near zero between late 2008 and late 2015 and has remained low since “liftoff” in December 2015.1 Other developed countries, such as Germany, Japan, and Switzerland, have recently sold new long-term debt at negative yields. This essay revisits some facts about interest rate behavior to provide context for the current situation.

NOTE: The gray bars indicate recessions as determined by the National Bureau of Economic Research.

SOURCE: FRED®, Federal Reserve Bank of St. Louis, November 2016; https://fred.stlouisfed.org/graph/?g=7Xhv.

The first figure shows monthly data for the effective federal funds rate and the yields on U.S. Treasury bonds at 1- and 10-year maturities since January 1955. All three rates show a similar long-term pattern: They were low until the mid-1960s. Then they started increasing, a trend that accelerated in the mid-1970s and reached its peak in the early 1980s. Since then, all the rates have been on a declining path.

The federal funds rate, which is an overnight rate, and the 1-year Treasury bond yield track each other very closely through the sample period, more so since the early 1980s. Although one can still argue about whether the Federal Reserve is dictating interest rates or, rather, accommodating market conditions at any particular time, the fact remains that short-term interest rates move closely in tandem.

In contrast, long-term interest rates, such as the 10-year Treasury bond yield, despite following the overall trend described previously, deviate markedly from short-term interest rates for significant periods of time. Since the 1980s, long-term interest rates appear to be well above short-term interest rates when the latter are temporarily low. In other words, the spread between short- and long-term interest rates is inversely related to the level of the short-term interest rate. This pattern can be clearly seen during the most recent recession, when short-term interest rates declined sharply to near zero, while long-term interest rates appeared to continue their gradual downward path.

NOTE: The gray bars indicate recessions as determined by the National Bureau of Economic Research.

SOURCE: Board of Governors of the Federal Reserve System (US) and Moody’s. Retrieved from FRED®, Federal Reserve Bank of St. Louis, November 2016; https://fred.stlouisfed.org/graph/?g=7Xkw.

The second figure compares the Aaa corporate bond rate with the federal funds rate and the 10-year Treasury bond yield. The yields of long-term corporate bonds move in tandem with long-term government bonds. The difference between the two rates reflects both risk and liquidity premia. Mortgage rates have similar properties.

NOTE: The gray bars indicate recessions as determined by the National Bureau of Economic Research.

SOURCE: FRED®, Federal Reserve Bank of St. Louis, November 2016; https://fred.stlouisfed.org/graph/?g=7XlV.

The third figure compares annual inflation, as measured by the year-over-year change in the consumer price index, with the 1-year Treasury bond yield.2 The rise in nominal interest rates until the early 1980s can be largely explained by an increase in inflation. Much of the subsequent steady decrease in interest rates can also be attributed to a decrease in inflation. Still, the real rate on government bonds (i.e., the difference between the nominal interest rate and inflation) has been trending downward as well. In fact, the real rate has been significantly negative since the end of the most recent recession.

What explains the decline in real rates? The jury is still out as economists study the issue and gather more evidence. A major factor is likely financial development. Government bonds have become easier to exchange and are a favorite option for corporations wanting to hold liquid assets. In other words, government bonds now resemble cash, which naturally implies low interest rates.3 For many purposes, especially at the corporate level, bonds are easier and safer to hold and use for transactions than cash or other money equivalents (e.g., demandable deposits). This may explain why, in the current low-inflation environment, the long-term government debt in some developed countries has a negative yield.

Another factor currently pushing nominal interest rates down is the “flight to safety.” There has been a dramatic increase in the demand for safe assets since the world financial crisis of 2007-08 and with the concurrent development of large developing economies such as China. Arguably, the supply of safe assets has not kept pace with demand, which contributes to the decline in yields of government debt deemed to be safe.

Finally, financial regulation (e.g., the Basel Accords and the Dodd-Frank Act of 2010) has trended toward providing more incentives for banks and other financial intermediaries to hold a larger proportion of safe assets, especially government debt. These regulations have contributed to the overall growth in the demand for safe assets and, hence, the decline in their yields.

Notes

1 See also Andolfatto, David and Varley, Michael. “Not All Interest Rates May Rise after Liftoff.” On the Economy (blog), Federal Reserve Bank of St. Louis, February 9, 2016; https://www.stlouisfed.org/on-the-economy/2016/february/not-all-interest-rates-rise-liftoff.

2 Comparing two yearly rates removes the potential effect of the term premium.

3 If cash and bonds were perfect substitutes (i.e., perfectly indistinguishable for practical purposes), then the interest rate on bonds should be zero.




Fernando M. Martin, "A Perspective on Nominal Interest Rates," Economic Synopses, No. 25, 2016. https://doi.org/10.20955/es.2016.25

The low long-term yield is likely a result of high foreign demand for Treasuries rather than a near-zero federal funds rate.

After keeping the federal funds rate close to zero for seven years, the Federal Open Market Committee (FOMC) increased its target rate by 25 basis points in December 2015. Additional 25-basis-point hikes followed in December 2016, March 2017, and June 2017, putting the rate at 1.0 to 1.25 percent. Clearly, the FOMC has initiated a new rate-hike cycle, and it is likely that the federal funds rate will rise further. According to the latest projections of FOMC participants, one more rate hike is expected this year, which would lift the federal funds rate by another 25 basis points.

The thin black line in the figure plots the federal funds rate from 1998 to now. The federal funds rate, which is the overnight borrowing rate among commercial banks, varied significantly before the financial crisis, peaking at 6.5 percent in 2000 and dropping rapidly to 1.25 percent in response to the 2001 recession. The Federal Reserve started raising the rate in the second quarter of 2004 and quickly pushed it to 5.25 percent, where it stayed until right before the financial crisis. After the financial crisis, the federal funds rate remained low until the end of 2015. 

Is it likely that the federal funds rate will reach the heights seen in the previous cycles? If not, how high might it go? Let's start by examining the long-term interest rate (the light blue line in the figure), which is commonly measured by the 30-year Treasury yield. Even with considerable movement in the federal funds rate, the 30-year long-term yield declined consistently over the sample period, from around 6 to 7 percent in the late 1990s to around just 3 percent today. This slow decline suggests that the low long-term yield is not a result of the close-to-zero federal funds rate that held from 2009 to 2015. The increasing foreign demand for U.S. government bonds is likely an important contributing factor to the decline of the long-term yield. The thick black line, using an inverted scale, shows the foreign holdings of U.S. Treasury securities. Foreigners have increased their holdings of U.S. Treasury securities sixfold, from around $1 trillion in 2000 to more than $6 trillion in 2017. As the foreign demand for Treasuries increases, the price of Treasury securities goes up and the yield goes down. Thus, the decline in long-term interest rates likely has more to do with increasing foreign demand for Treasury securities than federal funds rate policy. 

The figure also shows the 1-year (dark blue line) and 10-year (red line) Treasury yields. The 1-year Treasury yield follows the federal funds rate more closely than the long-term 10- and 30-year rates. The interest rate differential between the federal funds rate and the 1-year Treasury yield has been small throughout the period. This is not surprising given that the federal funds rate is a very short-term interest rate. Overnight interest rates should be more closely related to the short-term Treasury yields than to the long-term yields. In other words, the influence of the federal funds rate on Treasury yields diminishes with matur­ity. The federal funds rate strongly influences short-term yields, but this influence gets weaker as the maturity increases. Going forward, it is unlikely that the long-term rate will increase as much as the federal funds rate. 

So how high might the federal funds rate go? The low long-term yield might affect the FOMC's decisionmaking on the federal funds rate target. If a series of rate hikes were to increase short-term rates, with little change in long-term rates, short-term rates could surpass long-term rates. This phenomenon is referred to as the inverted yield curve and is believed to be a strong indicator of recessions. It occurred before the 2001 and 2007-09 recessions, as shown in the figure. The Federal Reserve quickly responded in each instance by dropping the federal funds rate target, explaining why the federal funds rate did not exceed the long-term yield by a large margin for extended periods. Hence, it is unreasonable to expect the federal funds rate to reach 5 or 6 percent during the current rate-hike cycle because of the low long-term yield. The projections of the federal funds rate for the next few years seem to be consistent with this discussion. The median projection of FOMC participants is 2.1 percent and 2.9 percent by the end of 2018 and 2019, respectively, which is close to the long-term yield.1 Using federal funds rate futures, the market's prediction of the federal funds rate is even lower for the same periods—only 1.5 percent and 1.65 percent, respectively.2

Notes

1 FOMC. "Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents Under Their Individual Assessments of Projected Appropriate Monetary Policy." June 2017; https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20170614.pdf.

2 Bloomberg as of June 26, 2017.




YiLi Chien and Paul Morris, "The Rising Federal Funds Rate in the Current Low Long-Term Interest Rate Environment," Economic Synopses, No. 10, 2017. https://doi.org/10.20955/es.2017.10

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