Understanding why interest rates are low

Why are interest rates so low? Many would blame the government, says Ben Bernanke, distinguished fellow in residence with the Economic Studies Program at the Brookings Institution.

But, the former chair of the Federal Reserve says it’s the state of the economy, in fact, that is the basis for rates. “This helps explain why real interest rates are low throughout the industrialized world, not just in the United States [and Canada],” he says in his blog.

Bernanke cites three economic factors causing today’s low-rate environment. Let’s look at them.

1. Secular stagnation

Economist Alvin Hansen coined the term secular stagnation in 1938. It states that tepid investment spending, coupled with subdued household consumption, will likely prevent full employment for years.

Sound familiar? It should, because we’re currently in a period of secular stagnation, where the economy is slowing and people are having trouble finding jobs.

So, in order to stimulate the economy, the Federal Reserve and Bank of Canada are keeping interest rates low. They’re hoping consumers and businesses will borrow money if the interest rate on a loan, for instance, is low. They’ll then use those funds to invest, buy goods or hire more people.

2. The global savings glut

This theory means that across the world, there’s an excess of desired saving over desired investment. Bernanke says this excess is happening primarily because of savings in “China and other Asian emerging market economies and oil producers like Saudi Arabia.” Right now, countries like China and Saudi Arabia are exporting more than they import, while the U.S. is importing more than it exports. That causes imbalance between global economies, and right now, there is more exporting around the world than there is importing.

So what?

Global central banks want greater balance. To do that, they are keeping interest rates low to encourage countries to spend their excess savings.

There’s good news: China is starting to reduce its exports and invest in its own economy. And low oil prices are reducing the dollar amount that Saudi Arabia is exporting. So, Bernanke says global economies will soon be saving less, which could lead to higher interest rates in the future.

3. Term premiums

Long-term rates have remained low. Bernanke explains that to understand the behaviour of long-term rates, look to the components that make up the yield of a bond: expected inflation, expectations about the future path of real short-term interest rates, and a term premium. The last component is “the extra return that lenders demand to hold a longer-term bond instead of investing in a series of short-term securities,” notes Bernanke.

Both inflation and short-term rates are expected to remain low, he says. Meanwhile, the low level of term premiums, which have recently been zero or even slightly negative, also means interest rates aren’t moving up any time soon.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.