Long-term interest rates rose noticeably in the last two months of 2013, with the yield on the 10-year U.S. Treasury note moving back above 3 percent during the year’s final trading sessions. What explains this run-up in rates?
And what do higher long rates mean for the American economy, going forward? These are key questions facing economists and policymakers in the earliest days of the New Year.
It is tempting, of course, to attribute the rise in long-term interest rates to the Federal Reserve’s decision, made at the December 18 meeting of the Federal Open Market Committee (FOMC), to being scaling back its massive bond-buying program. Indeed, Federal Reserve officials have encouraged us to think in this way, by arguing, previously, that those “Large Scale Asset Purchases” were intended, primarily, to lower long-term rates after the FOMC’s more traditional policy lever, the short-term federal funds rate, reached its zero lower bound.
But it is important to recognize that the FOMC did not terminate its bond-buying programs at that December meeting – far from it. Instead, FOMC members simply agreed to scale back the size of that program, from $85 billion to $75 billion per month. It seems highly unlikely that an adjustment of that kind – large in absolute dollar amounts, but quite modest in percentage point terms – could have such a large effect on long-term rates, especially considering that that move to “taper” had been anticipated for quite some time.
But if a change in Fed policy is not the root cause of the rise in long-term rates, what is? To answer this question, it is helpful to break long-term bond rates down into their components, and consider the behavior and determinants of each. The economist Irving Fisher was one of the first to explain how a nominal – or dollar-denominated – interest rate can be decomposed as the sum of two terms. The first is the real interest rate, which measures the rate at which a society is able to transform “goods today” into “goods in the future” through investment projects that are costly today, but expand an economy’s productive capacity in the future. The second is the inflation rate, which must be built into nominal bond yields to compensate savers for the loss in purchasing power that they would otherwise suffer when prices rise between the time they lend funds by buying bonds and the time they are repaid because the bonds mature.
With expectations of long-run inflation remaining stable, thanks largely to the Federal Reserve’s own commitment to its two percent inflation target, it is seems most likely that of Fisher’s two terms, it is the real interest rate component that is the strongest driver of higher long-term bond yields. Viewed in this light, we can see how the recent run-up in interest rates fits into some of the other positive economic developments that I have written about before.
When businesses see that economic conditions are improving and move to expand their operations, and when entrepreneurs find more exciting and profitable projects that they wish to get off the ground, their demand for funds to finance those activities rises. This increase in the demand for funds, similar to an increase in demand for any other good in any other market, puts upward pressure on the good’s price. And in the case of funds to finance long-term investment projects, the “price” is none other than the long-term real interest rate.
And so, in a roundabout way, this does bring us back to the Fed. Federal Reserve policy is probably not the principal cause of the rise in long-term interest rates. Instead, Federal Reserve officials are responding to the same more fundamental factors that are driving long-term rates higher. The economy is improving, and needs less support from the Fed. Hence the FOMC has begun to scale back its bond buying.
But those same improving economic conditions are also paving the way for a rebound in investment and entrepreneurial activity that is much stronger than we have seen so far during the recovery from the last recession. Interest rates have moved higher and will probably move higher still, as the demand for funds to finance those activities continues to expand. But that is probably a good thing: another sign of improvement and an omen of even better days to come.
Peter Ireland is an economics professor at Boston College and a member of the Shadow Open Market Committee.