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Why Are Interest Rates Still So Low?

by David Van Meter, M.S.Acc., Ph.D.


MyFutureOwl.com - Low Interest Rates

As I write this in the Summer of 2015, the three-month T-Bill is yielding approximately 0% (that's right, zero), and short-term CD rates at local banks run at about 0.10%. Nominal interest rates have been consistently low since 2009, much to the chagrin of savers and income-oriented investors alike. Worse still, real interest rates (that is, interest rates after taking inflation into account) on short-term savings have actually been negative since 2009. In other words, if I buy that 0.10% CD at the bank across the street, and inflation is running at 2.0% annually, then my real return on my savings is a negative 1.95% (calculated using the Fisher equation)! This means I am effectively paying the bank to hold my savings.

Why are interest rates still so low, nearly seven years after the great liquidity crisis of 2008? Are rates likely to rise significantly any time in the near future? What does all of this mean for investors like you?

In thinking rationally about the future of interest rates, we must first note the recent activities of central banks around the world. In the US, while the Federal Reserve has finally discontinued its process of quantitative easing, or buying various mortgage-backed securities and government bonds on the open markets in order to increase the liquidity of commercial banks, the Fed is continuing to deploy its other traditional easy-money policies, such as the Fed Funds Rate, to keep rates low. At this point, the Fed still has about $3.5 trillion in securities on its balance sheet, and it may well retain those securities for years to come.

In Europe, central bankers are pursuing easy money policies even more drastically in the search for economic growth. For the past year the European Central Bank has set its benchmark interbank lending rate to slightly below 0%, and even more jarringly, has imposed a negative interest rates of on some bank deposits. Admittedly, Europe is perilously close to a deflationary monetary environment, with its annualized inflation rate ranging from -0.6% to 0.3% over the past six months, and thus such bold actions are arguably necessary. In addition, the Bank of England and the Bank of Japan both have quantitative easing programs in place, and dozens of nations are keeping their benchmark rates well below 1%.

But there are some signs that structural changes in our monetary systems may herald some unexpected implications for the future of interest rates as well. For example, as a matter of not-so-distant history, the circulation of paper money in an economy served as a check on the extent to which interest rates could approach, or even fall below, zero. Think about it: if the bank is charging you to deposit your money, what is to keep you from withdrawing your money as cash and burying it in a steel box in the basement? Well, today cash increasingly means electronic funds transactions, with the result that we seldom use paper currency or its tangible substitutes, such as checks, in our daily lives. Many of our adult children don't even own checkbooks, and they think that carrying paper money in a wallet or purse is inconvenient. When my daughter and I go out for a cup of coffee, she pays with her smart phone while I pull some crumpled dollar bills out of my wallet (channeling Cicero, "O tempora! O mores!").

A few economists are starting to wonder aloud if the shrinking use of paper currency might pave the way for substantive fiscal and monetary changes. Fiscally, the increased use of electronic money (and the record-keeping trail it leaves) is certainly awakening taxation authorities around the globe to the possibilities for more efficient revenue collection and even new tax revenue sources. Monetarily, a broad acceptance of electronic money (in its functions as a store of value and a means of exchange) may lead to a corresponding willingness to accept very low and even slightly negative short-term interest rates as the price for the convenience of accessing your wealth with a mere wave of your smart phone or a swipe of your favorite card. If so, central bankers will have even more room for deploying monetary policies that entail using low or even negative interest rates to stimulate the economy, and they may also discover new incentives for keeping inflation rates lower than the 2% or so norms that have, in the past, made such bankers comfortable.

What does this mean for investors? Essentially this: the floor of 0% that we thought we stood upon for decades may now be lowered. Ouch! Some bond-market analysts now project that the 10-year Treasury bond will yield somewhere between 3.25%-to-3.40% within the year, up from about 2.40% today; but such expectations for higher yields have been dashed repeatedly in the past several years, and so we take these current projections with a grain of salt. So too, risk-free assets such as T-Bills may possibly continue to carry very low nominal interest rates and thus possibly negative real interest rates for not months but rather years to come, which would suggest that income investors may continue to prefer to riskier types of bonds and other securities in a search for yield, which in turn will support already high bond prices to some extent. This also means that the central banks are essentially underwriting some of the risk of assets such as corporate bonds and stocks, by keeping the risk-free rate so close to zero. On the other hand, if these conditions prevail, then inflation may remain lower than we have seen between, say, the Nixon and the Bush years.

Thus, important questions remain unanswered. How long can we expect the so-called risk free rates, which determine short-term interest rates and also discount our expectations of returns on riskier assets, to remain close to zero? Is it possible that subtle changes in the money supply may have given central bankers new latitude in their efforts to stimulate and our economies and manage inflation? If so, what effects will this have on our expectations regarding asset prices and returns on riskier assets? Nobody knows the answers to these questions with any certainty. What is certain is that our economy continues to change, offering unexpected opportunities and unexpected risks as well. As always, consult with your financial advisor to come to terms with your comfort with risk in the effort to maximize your wealth in these trying and yet exciting times.

Photo credit: Frankie Leon @ Flickr

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