Interest Rates: The Very Long View

I liked a picture that Barry Ritholtz put up the other day showing interest rates over the past half century or so, and it got me to thinking. In particular, I wondered which was more anomalous: the clear upward trend in interest rates during the period 1965-1982, or the clear downward trend in interest rates since 1982?

As part of an answer, I put together the following chart, using data from the NBER Macrohistory Database. It shows interest rates in the US over the past 145 years. (I tried to pick historical series that were as close as possible to the risk and duration of the modern 10-year government bond.)

The answer to my original question seems clear: the 1960s and 70s were unusual, and the steady fall in interest rates over the past 20 years seems to simply reflect a reversion back to historical levels.

An obvious thing to wonder next is why interest rates rose so much during the 1970s. One possible answer is that inflation was unprecedentedly high during that period, and so the high yields shown above simply reflect added compensation for inflation. In other words, perhaps there was only a rise in nominal yields, but not in real yields.

It turns out that this is not a sufficient explanation. The next picture shows the overall inflation rate in the US since 1875. Yes, inflation was unusually high during the late 1970s and early 1980s, but there were other episodes in history with inflation rates as high or higher (e.g. 1916-1920 and 1946-1949) but when interest rates did not rise dramatically.

Clearly there are other forces at work. Two possible explanations come to mind for me (and I’m sure there are others). One possibility is that during the pre-1950 period investors didn’t demand higher bond yields during inflationary periods because inflationary episodes were typically followed by episodes of deflation. So over the life of the bond, current inflation was not a major concern. By the 1970s, however, investors had seen 40 years of inflation without any subsequent deflationary period, and so they demanded greater compensation for current inflation.

A second possibility is monetary policy. One important contributor to higher long-term interest rates in the 1970s and early 1980s was the Fed’s decision to push short-term interest rates extraordinarily high. This did not happen during earlier inflationary periods.

Regardless, two implications of this very long view seems apparent: today’s low interest rates are much more the rule than the exception in US history; and it seems likely that we are at or near the end of the great 20-year bull market in bonds.