The Mystery of Low Interest Rates

Anyone who watches a few minutes of business news every now and then is aware that the Federal Reserve's interest rate decisions are watched very closely. However, most don't fully understand how the implications of the Fed's decisions.

Most people know that we have had historically low interest rates for a historically long time. And many people know that the Federal Reserve lowered rates during the Great Recession to stimulate lending, business expansion, job creation, and spending.

This has been effective but most don’t know the whole story with low rates. If you ask an economist for an explanation your eyes will soon glaze over, immersed in jargon. Remember too, practitioners of The Dismal Science have an explanatory and predictive batting average of about .500, rates up or down, which my high school probability class told me was “chance.”

Fortunately, a recent article in the Financial Times by one John Authers can help clear the air a bit. First of all, he points to our old friend, supply and demand. When demand for US bonds, T-bills and such, is high, interest rates remain low. Rates go up to draw buyers to fund our national debt when there are other competitive choices. And the world economy is unsettled, so people want to invest in the security of US bonds. Money floods in. This pushes rates down.

Secondly, the US economy has responded slowly to the low rate stimulus, because corporate muck-a-mucks are fearful of sticking their necks out after being so badly burned in 2008. This has been different than past, milder recessions where corporations were quicker to “get back in the game.” So limited investment and hiring leads to limited growth, which, in turn, leads to inflation remaining low and the Fed keeping rates low as a result.

Thirdly, the stock market has been on a historic bull run, so people would rather put their money there than in interest bearing bonds. Companies cut back overhead during the recession so profits went up and prices followed. Therefore, their cash hoards are at record levels and the higher stock prices reflect not only increased profits but more cash to raise value.

So, bottom line, fear is still ascendant over greed. And we know how much markets are driven by psychology, especially herd mentality.

Next, with China, Brazil and other previously fast track emerging economies slowing, more money has been funneled into the US for safety and opportunity, putting additional downward pressure on rates. Again, money comes in, rates go down. No incentive to buy bonds needed.

The last big player in this saga is technology. Fracking, specifically. The US has been pumping so much more oil and gas in the last decade that we have become exporters instead of importers. Coupled with the rivalry between Saudi Arabia and Iran over market share, their individual decisions on unrestrained oil pumping have kept oil prices at a decade low.

So, cheap oil has helped keep down costs, which has led to low inflation expectations, which has led to low bond yields. And low bond prices as I said, support stock prices remaining up. So we seem to have fallen into a “perfect storm” of factors to keep interest rates in the US low.

Low rates are bad news for retirees and others dependent upon interest rate income, but good news for those among us who financed a record number of cars in the last year and good news for new highs in housing prices in many markets. Winners and losers in a not-quite-zero-sum game. Stay tuned however, for money is fungible and all economic parameters cycle, if unpredictably. So economists will always have jobs reading tea leaves.