What Conundrum?

As Greenspan discussed at length earlier this week in his semi-annual report to Congress, economists still have no clear-cut explanation for the “conundrum” (or Interest Rate Mystery, as I like to call it) of stubbornly low long-term interest rates in the US.

But perhaps that’s because there really is no conundrum. Perhaps the US’s surprisingly low long-term rates are actually not that low. Perhaps US interest rates have indeed been pushed up in the past year, as many economists have been predicting they would. Perhaps the expected rise in long-term rates in the US has simply been masked by a simultaneous world-wide fall in interest rates.

Put another way: perhaps the only reason we haven’t seen more obvious signs of long-term interest rates rising in the US is that there has simultaneously been a worldwide downward trend in interest rates that has offset such a rise. The behavior of interest rates last week in the wake of China’s revaluation (which I discussed in the previous post) provides one small example of this larger trend.

The following chart illustrates. It shows long-term interest rates (measured by the yield on the 10-year government bond) in several countries over the past year and a half. All around the world, long-term interest rates have clearly trended down for the past year or so – except in the US (represented by the heavy black line), where they have stubbornly remained in the range of 4.0%-4.5%.

Note: the series for Germany/France is an average of interest rates for Germany and France, used because their interest rates are extremely close (within 5-7 basis points throughout this time period). July rates are taken as the average interest rate for the middle two weeks in July.

The following table provides more details about this divergence between interest rate behavior in the US and the rest of the world. The first column shows by how much long-term interest rates have fallen since January 2004, thus corresponding to the changes between the starting and ending points in the chart above. With the single exception of Japan, all of the non-US countries have enjoyed a fall in long-term interest rates of between 0.5%-1.0% since early 2004. US long-term rates, on the other hand, are virtually unchanged.

The second column shows the average interest rate differential between each of the countries listed and the US from 2000 to 2003. For example, the government bonds of France and Germany typically paid an interest rate around 0.1%-0.2% lower than the equivalent US government bond, while Canadian government bond yields were typically about 0.7% higher than US yields through the first four years of this decade.

Yet the final column shows that currently all of the countries in this sample, again with the exception of Japan, have seen the yield on their government bonds fall – in most cases, quite substantially – relative to the long-term interest rate that the US government must pay to borrow money. Even Canadian bonds, which have typically had to pay significantly higher yields than US bonds, are now enjoying lower interest rates than equivalent US bonds.

So while long-term interest rates have generally been trending downward around the world over the past year or so, the US has missed out on this global fall in interest rates. Put another way, the US has enjoyed the global fall in interest rates, but it has only served to counteract other forces that have been simultaneously driving long-term rates up in the US, so that the net result is that long-term interest rates in the US have remained stable for quite some time now.

Seen in this light, the “conundrum” may need to be rephrased. Instead of wondering why long-term interest rates in the US have stayed so low, we need to answer the following two questions: (1) What is behind the seemingly global decline in interest rates of the past year or so; and (2) Why has the US missed out on this fall in interest rates? Why are long-term interest rates in the US so high by comparison to the rest of the world?

More on these questions later.