Influential Factors
There are several important reasons to think that rates ought to be headed up: high oil prices; high and continuing federal budget deficits; and the record-high and ever-increasing current account deficit (for more on the current account deficit, see “Looming Issue,” Multifamily Executive, July 2005, page 37). But there are also good reasons to think rates could go lower, such as low inflation; cooling global demand despite increased global production; and foreign central bank buying of U.S. Treasury securities.
To sort out these disparate influences, it helps to distinguish factors that affect the inflation premium from those that affect factors such as the underlying supply of and demand for credit. Let’s begin with credit.
Large budget deficits increase borrowing by the federal government, adding to overall demand for credit. As with any increase in demand, deficit spending tends to raise interest rates. Some dispute this conclusion, pointing out that a high deficit isn’t always associated with high interest rates.
But this misses the point, which is that government borrowing raises interest rates higher than where they otherwise would have been. The cost of credit is influenced by many factors that are constantly changing, making this simple correlation (e.g., more government borrowing equals higher interest rates) hard to find without sophisticated analytical tools.
In a similar vein, our current account deficit requires us to borrow an equivalent amount to finance our overspending–in this case, more domestic spending (by consumers, business, and government) than can be financed by domestic saving. Given the record, and growing, current account deficit, both in absolute amount and also relative to the size of the overall economy, this represents a substantial addition to the demand for credit.
On the other side of the ledger, however, the global demand for credit is slipping due to the slowdown in global economic growth this year. In addition, foreign central banks, especially in China and other Asian countries, have been increasing the supply of funds available for U.S. borrowing. The fact that real interest rates have remained low and range-bound for so long thus reflects not an absence of forces to the contrary, but rather a delicate balance among offsetting factors.
To some extent, the same is true regarding the portion of interest rates that reflects the inflation premium. Clearly, the continued increase in the price of oil (and other key commodities) in recent years has the potential to ratchet inflation up. That is what happened in the past. In the 1970s, the surge in oil prices caused inflation to rise, even accelerate, thereby pushing interest rates up. The reverse happened in the 1980s, as sharply lower oil prices lowered inflation, inflation expectations, and interest rates.
Beyond oil prices, continued U.S. economic growth, as well as a rebound in industrial production and capacity utilization, has led the Federal Reserve to tighten monetary policy. Ironically, the Fed’s well-earned reputation as an inflation fighter has reduced market worries about resurgent inflation–there has been no meaningful increase in the inflation premium in interest rates.
At the same time, the combination of increased global production and declining global economic growth has produced greater competition among producers–both in goods and in services–so that producers have not gained pricing power. This has not only generally kept inflation low; it also has greatly impeded the transmission of higher energy costs to other sectors.
Future Forecast
As long as the forces pushing interest rates up remain balanced by those pushing interest rates down, there is no reason for interest rates to change very much. Can this continue?
It seems to me that we could easily see interest rates remain low (i.e., a 10-year Treasury yield of less than 4.5 percent) for the next year or so. Of greatest import may be the slowing global, and American, economy, particularly when combined with unabated global competition. The combined effect will not only keep inflation low (thereby keeping the inflation premium low), but also prevent borrowing demands from rising, which will keep real interest rates low as well.
But at some point, interest rates will almost surely have to adjust upward. Even if inflation remains low, the borrowing demands of both a rising federal budget deficit (absent a substantial reversal of current policy) and, even more, the rising current account deficit are likely to run up against reduced willingness of foreign central banks to finance our profligate spending. The recent move by China to permit its currency to float, at least within a narrow band, may not have much immediate impact but could be the beginning of much longer-reaching changes.
How far could rates back up? Over the course of the 1990s, the 10-year Treasury yield averaged about 6.5 percent, which translates into a real rate of about 3.5 percent on top of 3.0 percent inflation. That certainly seems within the realm of possibility.