Long-Term Interest Rates, Now and Then

A report by the White House Council of Economic Advisors surveys long-term interest rates. The “key takeaways” include:

Real and nominal interest rates in the United States have been on a steady decline since the mid-1980s. Declining interest rates are a global phenomenon. … [F]orecasters largely missed the secular decline of the last three decades.

The Ramsey growth model implies a link between labor productivity growth, per capita consumption growth and the real (inflation-adjusted) interest rate. Historically, periods of low real long-term interest rates have tended to coincide with low labor productivity growth. Projections of labor productivity growth, while imprecise, suggest 10-year real interest rates in the range of 1.5 to 3.5 per cent.

Asset-pricing models that incorporate risk suggest that the long-run nominal interest rate is the sum of expected future short-term real rates, expected future inflation rates, and a term premium. The 10-year rate in ten years that forward transactions in nominal Treasuries imply is currently 3.1 percent. Forward transactions in the market for TIPS suggest a long-term real rate just above 1.00 percent in ten years. Adding the CPI inflation rate implied by the Federal Reserve’s PCE inflation target would imply a forward nominal interest rate of 3.25 percent. The term premium in nominal Treasuries is currently estimated to be near zero, with a 2005-2014 mean of 1 percent. These components together suggest a 10-year nominal interest rate in the range of 3.1 (forward Treasuries) to 4.6 percent (based on FOMC forecasts of the long-run federal funds rate).

In a world with financially integrated national capital markets, the general level of world interest rates is determined by the equality of the global supply of saving and global investment demand. Capital markets of advanced economies are now tightly integrated while emerging market economies are becoming increasingly integrated into the global financial system. Low-income economies remain partially segmented from the global capital market. As a consequence of increasing international market integration, long-term real and nominal interest rates are increasingly moving in tandem and have declined along with U.S. rates. Nominal interest rates also tend to be correlated across countries though differences in inflation expectations can produce differences in nominal rates. In a world with uncertainty, global long-term real and nominal interest rates will include risk premiums that can reflect country-specific risk factors. Strong economic linkages, however, reinforce substantial correlation in countries’ long-term bond risk premiums.

Long-term interest rates are lower now than they were thirty years ago, reflecting an outward shift in the global supply curve of saving relative to global investment demand. It remains an open question whether the underlying factors producing current low rates are transitory, or imply long-run equilibrium long-term interest rates lower than before the financial crisis. Factors that are likely to dissipate over time—and therefore could lead to higher rates in the future—include current fiscal, monetary, and exchange rate policies; low-inflation risk as reflected in the term premium; and private-sector deleveraging in the aftermath of the global financial crisis. Factors that are more likely to persist—suggesting that low interest rates could be a long-run phenomenon—include lower forecasts of global output and productivity growth, demographic shifts, global demand for safe assets outstripping supply, and the impact of tail risks and fundamental uncertainty.