Why are long-term interest rates low?

• Author: David Hauner/Manmohan S. Kumar
• Position: IMF Fiscal Affairs Department
• Pages: 140-141

Page 140

Long-term interest rates have remained low in the Group of Seven (G7) major industrial countries despite large fiscal deficits and rising public debts. Is this a sign that the factors affecting interest rates have changed? In this era of global capital mobility, is there, as some observers claim, a "new economy" of interest rates that involves a radically different relationship between interest rates and what have traditionally been considered as their determinants, including fiscal imbalances? A new IMF Working Paper argues that factors that are likely to be transitory have masked the effects of traditional determinants and lulled policymakers into a false sense of security. There may be a rude surprise in store, argue authors Manmohan Kumar and David Hauner.

Recent discussions of the evolution of global long-term interest rates have tended to ignore a marked deterioration in the fiscal positions of some of the largest industrial economies since the mid- to late 1990s. The ratio of public debt to GDP has risen very significantly over the past 10 years in Japan; in the other G7 countries the rise has been far less dramatic but still quite noticeable: in the United States it has risen by more than 4 percentage points since its trough in 2001, and in several large European Union countries, it has risen by between 5 and 10 percentage points.

While deficits and debts have risen, nominal and real long-term interest rates have remained very low (see chart) despite an up-tick in early 2006. Low long-term rates-by allowing government debt to rise without much increase in interest expenditures-reduce the incentive to address budgetary imbalances; in addition, the subdued behavior of bond yields-in the presence of fiscal imbalances as well as strong economic growth and a tightening of monetary policy in some cases-has prompted renewed doubts about the underlying links between government deficits and debt and interest rates.

Why rates could be low

While it is clear that long-run real interest rates should be determined by ex ante rates of saving and investment, empirical studies show that the determinants of both saving and investment, and, thereby, of real interest rates vary significantly across countries and over time. This is particularly true for the effects of government borrowing on interest rates. According to a widely cited survey (Gale...