In 1979, the English rock band, the Electric Light Orchestra released a song titled, Don’t Bring Me Down. The song was written by Jeff Lynne and was dedicated to the Skylab space station, which re-entered the Earth's atmosphere that same year. One thing that has not entered the atmosphere during the current business cycle is interest rates. Over the course of the business cycle (from the bottom of the last recession) the benchmark 10-year rate has barely budged. The 10-year yield was 2.08 percent in mid-June, actually below the yield at the very bottom of the recession. Over the course of the growth portion of the business cycle, the 10-year yield fell to as low as 1.38 percent. With inflation averaging about 2 percent, interest rates over the course of the business cycle have essentially been negative.
Economic theory would suggest that interest rates should rise over the course of a recovery as consumers and firms increase borrowing to fund new purchases and investments. However, beginning in 1987, things began to change, and during three of the last four recoveries interest rates continued to fall. There is really no solid economic theory that can explain this. Why would an increased demand for capital not result in an increase in its price?
Many economists and political pundits have suggested that the Federal Reserve Board of Governors is the culprit. While it is true that ever since Alan Greenspan became Chairman of the Fed in 1987, the bank has been dovish on monetary policy. But unlike what many economists may suggest, the Fed really has very little impact on market interest rates. In fact, while the Federal Funds rate has risen and fallen over the course of business cycles, the 10-year yield has consistently fallen, reaching a steady state at around 2 percent beginning in 2011.
It is really the demand for money and inflation that determine rates at the 10-year level, not Federal Reserve monetary policy, so there must be other reasons that rates have not risen over the course of the recovery. While many analysts have suggested reasons for falling interest rates, in reality there can only be three causes:
- The 1970s inflation anomaly;
- Increased supply of capital; and
- Reduced demand for capital.
Looking at the numbers historically, a large part of the downward trend came about through rates climbing down the mountain that occurred in the 1970s. Inflation peaked in 1980 at about 14.6 percent. At that time the 10-year yield was just 12.5 percent so real interest rates were actually negative. In fact, during much of the inflationary period between late 1978 and the end of 1980 real interest rates were consistently negative. Then the Federal Reserve actually stepped in and forced short term rates to record levels. This move worked its way into market rates and for the next 20 years, well into the next century, with real interest rates at historical highs, at levels not seen since the 1700 and 1800s.
Following this period, real interest rates have trended back down to the levels below one percent. Today, inflation sits at roughly 1.7 percent, and the 10-year yield is 2.08 percent, a real rate of about 0.4 percent.
This explains the long-term trend, however, since inflation tends to rise as the business cycle matures why not interest rates as well? If demand for money rises, should not its price? And with debt levels skyrocketing over the same period, it is incongruous that the price of money has continued to fall.
One thing that could lead to the decline over the course of the business cycle is that the supply of capital has outstripped demand. Statistics on the supply of money are a bit iffy since there are many different measures; however, even examining broad measures of global money supply, commercial debt alone has grown exponentially to the supply of money. So, it appears as if the supply of money has not risen with demand. This means that the laws of supply and demand may not apply to money.
Reduced inflation rightfully brought nominal interest rates down; however, demand for debt should bring real interest rates up. Stanley Fischer, former Vice Chairman of the Fed, suggested that slower expected growth due to decreased productivity and low labor force growth is the main cause of low interest rates since investors do not see much demand for money in the future. While this may have some effect, it is unlikely to offset current debt to savings ratios. Fischer also suggested that business was becoming less capital intensive so demand for credit was weakening. This does not seem to fit the current scenario where debt is piling up even if it is not being used for productive investments.
However, economic statistics don’t always tell the correct story, and quite often they misrepresent reality. During the last business cycle, central banks around the world engaged in something they called quantitative easing. In effect, they printed money and with that they purchased nearly every bond that they could, forcing the supply of credit well above the demand. This still continues in Japan, where the Bank of Japan, in an ill-fated attempt to stoke inflation, purchases every government bond, effectively eliminating the private market. Central banks have effectively created a huge supply of capital looking for demand. The only reason that this did not stoke a massive inflation is that it never really entered the economy, but rather sat on the books of central and commercial banks.
All of this means that the supply of capital is higher than standard monetary measures would suggest, and with demand weakening, interest rates should remain low.
In addition to the statistics not properly reflecting capital supply, the nature of investment itself is changing. One interesting theory is that as information and intangible assets like software or network effects have become a larger part of the capital input of most goods and services, and since these assets are not properly valued in GDP and other financial calculations, they are in effect hidden savings or hidden assets that are supplying capital to the markets at a faster rate than debt has grown. In effect, the value of a Facebook or an Uber is made up almost entirely in the value of their network effects and this is not measured in the capital account statistics. So, if Facebook borrows $100 to attract 100 more users it adds $100 to the debt calculation, but nothing to the asset side of the balance sheet. Maybe it is a coincidence that the internet boom and the first iterations of what became America Online (or AOL) began at about the same time as the general fall in nominal interest rates.
Whatever the case may be, low interest rates now dominate financial markets and are undergirding a huge amount of debt. Any marked increase in rates could lead to large dislocations, so understanding this phenomenon is extremely important, or the economy may reenter the atmosphere without a heat shield.
John Dunham is President of John Dunham & Associates. John Dunham & Associates, based in Brooklyn, has built its reputation as a leader in the field of tax and regulatory economics by producing economic impact studies that are clear, concise, and effective. They can be a great source for any of your stories needing economic analysis.
Written by John Dunham
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