What factors determine interest rates and why interest rates matters to the economy and your investment portfolio.
In this episode, you’ll learn:
- What are real rates.
- What is the equilibrium real rate of interest.
- What is full employment.
- How central bankers try to influence interest rates .
- How future short-term rates influence long-term rates.
- How can interest rates be negative.
- What are term premiums.
- How inflation expectations influence interest rates.
- What is secular stagnation.
Why Are Interest Rates So Low?
Global interest rates remain near their lowest levels in 35 years. To understand why, we have to start with interest rate theory and see how market forces apply that theory in practice.
Savers and Borrowers
The world is comprised of savers and borrowers. Savers want to earn a positive rate of return on their savings. Borrowers want access to that savings to invest in projects or to buy things.
For example, most institutional borrowers seek funds to invest in capital projects such as building a new factory that they believe will earn a rate of return that exceeds their borrowing cost.
Retail borrowers want to accelerate their future spending into the present to buy a house or car.
In theory, there is a rate of interest where the amount of funds savers want to save equals the amount of funds borrowers want to borrow.
This rate of interest is called the equilibrium real rate of interest.
A real interest rate is the market or nominal interest rate minus the expected rate of inflation.
The theory suggests that an economy that is at its equilibrium real interest rate will not only have ample profitable capital investment opportunities for businesses to earn rates of return above their borrowing costs, but there will be sufficient opportunities to ensure that everyone who want a job can get a job.
In other words, there is full employment.
That is the theory.
The Unobservable Real Rate
In practice, no one knows what the equilibrium real rate of interest is. It is unobservable.
The unemployment rate is observable, however, so if the unemployment rate is high then it is assumed that the real rate is not at its equilibrium because businesses are unwilling to invest in a sufficient number of capital projects that achieve full employment.
Central banks, such as the U.S. Federal Reserve, try to combat this situation when real rates are too high and not at their equilibrium by lowering short-term rates to what they believe is the equilibrium short-term real rate.
Central banks also try to encourage longer-term rates to settle near the unobservable real rate by communicating what the level of short-term interest rates might be in the future.
They do this because in theory a longer-term interest rate is partially comprised of a series of short-term rates. Both today’s short-term rate, but also expectations for future short-term rates.
For example, a business has a choice of borrowing money for ten years or it could borrow money for two years and then roll over the debt in two years and take out another two-year loan.
The business could take out a series of two-year loans instead of one 10-year loan.
Supply and demand for loans should ensure that the ten-year borrowing rate is at a level consistent with current two-year borrowing rates and expectations for future two-year borrowing rates.
Negative Interest Rates
For the past six years, the U.S. Federal Reserve has tried to lower unemployment by keeping short-term rates near zero and buying longer-term bonds as part of its quantitative easing program, all in an attempt to influence interest rates to settle near the equilibrium real rate that is consistent with full employment.
Some central banks, such as the European Central Bank and those in Sweden and Denmark have gone even further in an attempt to lower long-term rates.
They have set negative short-term rates.
A negative interest rate is when you pay a bank to hold your money instead of the bank paying you interest. Another example of a negative interest rate is buying a bond for a price that is greater than what you will receive back in interest and principle payments.
The ECB and the central banks in Sweden and Denmark are charging their member banks a fee (i.e. a negative interest rate) to hold money in their account in order to encourage them to lend.
The Risk of Too Low of Rates
One risk central banks face by keeping short-term interest rates too low for too long is they could encourage too much borrowing / capital investment, which could cause the economy to grow too quickly and overheat.
The competition for workers, equipment and supplies to build and staff new projects could push up wages and prices leading to inflation.
Because there is often a lag between a change in central bank monetary policy and its impact on the economy, central banks often increase short-term interest rates before all the evidence is in that an economy is improving for fear that inflation could accelerate.
Four Drivers of Interest Rates
So why are interest rates low?
Interest rates are low because the equilibrium real rate of interest needed to get businesses to pursue capital investment and hire more workers is low.
Interest rates are low because expectations for future short-term interest rates are low.
Interest rates are low because inflation expectations are low.
Finally, interest rates are low because the additional premium investors demand to own longer-term bonds over shorter-term bonds is also low.
The demand for longer-term safe assets such as government bonds and other top-tier investment grade securities is high as many investors remain risk averse and prefer the perceived safety of bonds over other risk assets, such as stocks.
These term premiums are also low because there is a reduced supply of safe assets as many former investment grade bonds have been downgraded in quality and much of the bond supply has been purchased by central banks as part of their quantitative easing programs.
Until there is a change in one or all of these drivers, interest rates will remain low.