What’s behind Recent Changes in Long-Term Interest Rates?

Martin Feldstein says we need to cut social programs so that we don’t “weaken demand in the near term and hurt economic incentives in the long run”:

The Fed must reassure markets on inflation, by Martin Feldstein, Commentary, Financial Times: The interest rate on 10-year US Treasury bonds almost doubled in six months, rising from 2.26 per cent last December to 3.98 per cent in mid-June, before decreasing slightly in recent days. This sharp rise happened despite the Federal Reserve’s … policy aimed at lowering long-term rates by buying $300bn of Treasuries and promising to buy more than $1,000bn of mortgage securities. …

There is no single reason for the sharp rise in rates… The simplest explanation for the higher 10-year rate is that many investors now expect inflation to rise. … The prospective decline of the dollar is also a potential source of inflation. …

But such an explanation is deceptively easy. … Those scared by Lehman Brothers’ collapse wanted the safety and liquidity of ordinary Treasury bonds, causing their yields to fall sharply…

Treasury yields rose this month to their level a year earlier because improving market conditions meant investors were no longer willing to pay for the extreme liquidity of Treasuries. Inflation was thus not the only, and perhaps not even the main, reason for the rise in rates.

Why did the Fed’s massive buying of long-term Treasury bonds not hold down the bond rate? The answer is that bond markets are less impressed by the $300bn of Fed purchases than by the official projection of $10,000bn of government borrowing over the next decade… The resulting crowding out of private investment will require higher future interest rates, and that is reflected in current long-term rates.

A further reason long rates remain high is a fear that foreign buyers may not be willing to continue buying dollar bonds to finance a large US current account deficit.

In short, higher long-term interest rates reflect investors’ concern about future inflation, future fiscal deficits and the future willingness of foreign investors to purchase US bonds. …

It would be wrong for the Obama administration and Congress to reduce the fiscal stimulus in 2009 or 2010, since there is no clear evidence of a sustained upturn. But it would be equally wrong to allow the national debt to double to 80 per cent of GDP a decade from now. Increasing taxes even more than proposed would weaken demand in the near term and hurt economic incentives in the long run. The fiscal deficit should therefore be reduced by curtailing the increases in social spending that the president advocated in his election campaign.

The Fed must also be careful not to tighten too soon. But it needs to reassure markets that it will prevent the excess reserves of the banks from financing a surge of inflationary lending when the economy begins to expand. It must make clear now that it will be willing to do so even if that involves big rises in short-term rates.

Here’s (my interpretation of) Paul Krugman’s argument about the source of recent movements in long-term interest rates:

There are two reasons long-term rates might rise, first more worries about the debt and inflation in the future would drive rates up, and second the prospect of better economic conditions in the future would have the same effect, rates would go up.

Suppose we receive bad news about the current state of the economy. That should cause expectations of lower output growth in the future, and hence lower tax revenues and higher spending on social programs than would exist with a stronger economy. So the bad news should cause an expectation of a larger deficit and more inflation worries, and that would drive long-term interest rates up (these worries would also make foreign central banks less likely to fund US borrowing which would reinforce the increase in long-term interest rates).

But if it is future economic conditions that are driving the changes in long-term interest rates, bad news about the economy should drive rates down.

Last week, we received bad news about the economy. If the debt/inflation/foreign lending story is correct, long-term rates should have gone up. If the state of the economy story is driving rates, rates should have fallen. What did long-term rates actually do? They fell.

About Mark Thoma 243 Articles

Affiliation: University of Oregon

Mark Thoma is a member of the Economics Department at the University of Oregon. He joined the UO faculty in 1987 and served as head of the Economics Department for five years. His research examines the effects that changes in monetary policy have on inflation, output, unemployment, interest rates and other macroeconomic variables with a focus on asymmetries in the response of these variables to policy changes, and on changes in the relationship between policy and the economy over time. He has also conducted research in other areas such as the relationship between the political party in power, and macroeconomic outcomes and using macroeconomic tools to predict transportation flows. He received his doctorate from Washington State University.

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