Greenspan on the Interest Rate Mystery

Greenspan made some remarks about the Interest Rate Mystery during a conference yesterday in Beijing. Slightly disconcertingly, none of the prevailing theories as to why long-term rates are so low right now are convincing to him… so he’s left admitting that he doesn’t really have an explanation for it.

The pronounced decline in U.S. Treasury long-term interest rates over the past year despite a 200-basis-point increase in our federal funds rate is clearly without recent precedent…

In March of this year, market participants… bid up long-term rates, but as occurred last year, forces came into play to make those increases short lived. But what are those forces? Clearly, they are not operating solely in the United States. Long-term rates have moved lower virtually everywhere. Except in Japan, rates among the other foreign Group of Seven countries have declined notably more than have rates in the United States.

So exactly why does Greenspan say that none of the prevailing theories explain the mystery? Here’s the summary:

  1. Low long-term rates signal expectations of future economic weakness. Perhaps this is part of the story, but Greenspan’s not convinced: “periodic signs of buoyancy in some areas of the global economy have not arrested the fall in rates.”
  2. Pension funds are scrambling to make up for unfunded liabilities by dumping money into long-term bonds. This explanation also seems insufficient: “world demographic trends are hardly news, and recent adjustments to funding shortfalls do not seem large enough to be more than a small part of a complete explanation.”
  3. Asian central bank (CB) accumulation of dollar assets has pushed down long-term yields. Greenspan finds this only a partial explanation: “given the depth of the market for long-term Treasury instruments, the Federal Reserve Board staff estimates that the effect of foreign official purchases has been modest. Furthermore, such purchases seem an implausible explanation of why yields on long-term non-U.S. sovereign debt instruments are so low.
  4. Economic integration has reduced worldwide inflation expectations and, through increased international capital flows, increased the pool of savings going toward long-term debt instruments. Because this phenomenon is not new to the last year, Greenspan is again unconvinced: “Although this explanation contributes to an understanding of the past decade, I do not believe it explains the decline of long-term interest rates over the past year despite rising short-term rates.”

So what’s his conclusion?

The economic and financial world is changing in ways that we still do not fully comprehend. Policymakers accordingly cannot always count on an ability to anticipate potentially adverse developments sufficiently in advance to effectively address them.

No, this isn’t a terribly reassuring comment from the world’s most important central banker, but at least it’s honest. Personally, I find theories #2 and #4 completely unconvincing as well, since those both describe long-term trends, not things that have changed in the past 12 months. So I suppose I’d guess that forces #1 and #3 may be acting together, each contributing part of the explanation.

Let me mention one possibility worth thinking more about in defense of theory #3 in particular: if long-term bonds of the US and other countries are fairly good substitutes for each other, and if Asian CB purchases of US bonds are driving down US interest rates, then this would also be expected to indirectly drive down interest rates in other countries by inducing private capital flows into non-US government bonds. Of course, in order to have a significant effect on worldwide long-term rates the flows from Asian CBs would have to be sizeable compared to the worldwide bond market, not just compared to the US treasury market. Five hundred billion dollars per year is a lot, but is it enough to move interest rates around the world? Maybe. But it’s a harder case to argue.

To be on the safe side, I think we should keep trying to come up with some other possible explanations for the Interest Rate Mystery