Former Fed chair Ben Bernanke announced on Monday, March 30th that he was inaugurating a new blog on the Brookings website. Bernanake says now that he is out of the spotlight, he can “once more comment on economic and financial issues without my words being put under the microscope by Fed watchers”, and he plans to use his new blog as an occasional forum.
How low can they go?
In his first blog, Ben Bernanke highlights that interest rates are “exceptionally low” by historical standards. For example, the U.S. government can borrow for ten years at a rate of about 1.9%, and for thirty years at about 2.5%, and other industrial countries have even lower rates. The yield on ten-year government bonds is currently close to 0.2% in Germany, 0.3% in Japan, and 1.6% in the UK. The yield on the 10-year note in Switzerland is actually slightly negative, “meaning that lenders must pay the Swiss government to hold their money!”
He points out that the interest rates paid by businesses and individuals are somewhat higher because of relative credit risk, but remain very low on an historical basis.
The former chairman of the federal reserve also emphasizes that low interest rates are not really a short-term issue, but part of a long-term trend. He offers a figure showing that ten-year government bond yields were relatively low in the 1960s, then soared to a peak above 15% in 1981, and have been gradually decreasing since then. Inflation has been the key factor in this long-term declining trend.
Ben Bernanke notes: “All else equal, investors demand higher yields when inflation is high to compensate them for the declining purchasing power of the dollars with which they expect to be repaid. But yields on inflation-protected bonds are also very low today; the real or inflation-adjusted return on lending to the U.S. government for five years is currently about minus 0.1 percent.”
Ben Bernanke explains equilibrium real interest rate
The average person in the street would answer the question “Why are interest rates so low?” by saying that the Fed is keeping them low. Ben Bernanke points out that’s only true in a narrow sense. The Fed does set the benchmark short-term interest rate. But the more important rate is the real, or inflation-adjusted, interest rate (ie, the market, or nominal, interest rate minus the inflation rate). Furthermore, the Fed’s ability to impact real rates of return, especially longer-term real rates, is quite limited. Real interest rates are the product of a broad range of economic factors, especially prospects for economic growth.
Ben Bernanke introduces the concept of the equilibrium real interest rate. The equilibrium interest rate is generally defined as the real interest rate consistent with full employment of labor and capital resources (after some period of adjustment). The equilibrium rate changes over time as labor and capital resources evolve. Theoretically, in a fast-growing economy, the equilibrium interest rate should be high, reflecting a high return on capital investments.
In a slowly growing or recessionary economy, the equilibrium real rate should be low, given limited and low-profit investment opportunities. Moreover, government spending and tax policies impact the equilibrium real rate; ie, big deficits will tend to increase the equilibrium real rate since government borrowing takes savings away from potential private investment.
Given the Fed mandate to create full employment of capital and labor resources, its job is really to use its influence over market interest rates to move rates toward levels consistent with the equilibrium rate, or as Ben Bernanke points out, “its best estimate of the equilibrium rate, which is not directly observable.”