January 2005

What Determines Interest Rates?

By John H. Makin
The pundits who have been predicting higher interest rates based on large U.S. budget and current account deficits have some explaining to do. Beyond the fact that very little systematic empirical evidence exists of a close link between deficits of any kind and interest rates, many high-profile commentators such as Robert Rubin and Pete Peterson, not to mention Pimcos Bill Gross, have consistently warned that long-term interest rates would rise as Americas budget and current account deficits rose. Actually, U.S. longterm interest rates have been fallingfrom 4.8 percent in early June to 4.1 percent at year-end. Despite this stellar performance, Gross has even gone so far as to suggest that U.S. government liabilities should be downgraded from their top rating of AAA to AA. It is odd that the broad field of U.S. deficit bemoaners, including a former Treasury secretary, an immensely successful investor, and the manager of the worlds largest bond fund, have chosen to mislead the public on the major determinants of interest rates. In order to rationalize the awkward fact that interest rates on ten-year Treasury notes have gone down this year, the disaster that these pundits are calling for in the bond market has to be looming in the future. The consequences, it is assumed, are visible only to the prognosticator and somehow are invisible to the bond market. For the benefit of this distinguished group and the rest of us who need to have some idea where interest rates are going, I offer here a basic primer on the determinants of interest rates.
John H. Makin ([email protected]) is a visiting scholar at AEI.

Proximate Determinants of Interest Rates

I shall focus primarily on a typical government security, the ten-year U.S. Treasury note. The first thing to remember about a Treasury note is that it serves to store wealth over time. The interest rate on that note, which must compete with all other means of storing wealth, is roughly determined by the sum of the real (adjusted for inflation) interest rate and expected inflation over the life of the bond. The real interest rate on ten-year Treasury notes over the long run varies as real returns on alternative assets vary. If, other things equal, the stock market is rising as a reflection of rapidly rising investment opportunities, then the real return on stocks (an alternative financial asset to bonds) will rise and, other things equal, the return on bonds will rise. It is no accident then that during the rapid run-up in the stock market from 1998 to 2000, the yield on ten-year Treasury notes rose from just above 4 percent to 6.5 percent. In effect, bonds had to compete with a rapidly rising stock market and therefore had to pay a higher real (inflationadjusted) rate of return. The other major determinant of interest rates on Treasury notes is the expected rate of inflation over the life of the Treasury instrument. Since the interest on U.S. Treasury notes is paid in dollars, expected inflation measures the rate at which dollars depreciate against goods over the life of the bond. Therefore, an expectation of higher inflation, which will depreciate the value of interest payments and the principle on a ten-year Treasury note, means that an investor must earn a higher interest rate to compensate for the loss of
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-2rates, the impact on shorter-term securities like two-year purchasing power that higher expected inflation would notes has been more noticeable, with yields rising on twoentail. In effect, higher inflation makes a bond that is payyear notes by about 40 basis points during the time when ing fixed interest a less attractive way to store wealth. the Fed was increasing the federal funds rate by 125 basis Therefore, higher and more volatile inflation depresses points. bond prices while boosting the yield, which The behavior of longer-term interest moves inversely with the price of a bond. It is especially rates as the Fed has increased the federal The U.S. government does offer Treainteresting to see funds rate suggests either that the expected sury notes that are protected against inflareal return has been reduced during the time tion. By comparing the yield on ten-year that the yield on that the Fed has been raising the federal Treasury inflation-protection securities ten-year Treasury funds rate, or that expected inflation has (TIPS) with the yield on regular Treasury notes, it is possible to infer the inflation notes has been flat to fallen. Actually, a reduction of about 75 basis points in the expected real yield on rate expected by investors over the life of the ten-year note and the expected real lower as U.S. external ten-year Treasury notes since June has reduced the nominal yield on ten-year Treareturn on Treasury notes. Currently, the deficits have risen. sury notes even as the Fed has raised shortexpected inflation rate over the next ten term rates. This outcome suggests that years implied by the TIPS yield is about 2.5 markets expect economic growth, a rough proxy for the percent. The remainder, 1.75 percent on a bond paying a expected real yield, to slow in the future. nominal yield of 4.25 percent, is the expected real return It is especially interesting to see that the yield on tenon the ten-year notes. Based on past history, 1.75 percent year Treasury notes has been flat to lower as U.S. external is somewhat low but probably reflects the fact that rates deficits have risen. Another way of describing the rise in of return on invested capital have been driven down over U.S. external deficits is to suggest that the supply of dollars the past several years by the widespread search for ways going into foreign exchange markets through the U.S. curto store wealth in a world where wealth is rising rapidly. rent account deficit has increased to nearly $2 billion per Beyond that, excess capacity exists in the global tradedday. For the U.S. dollar to remain stable, foreign investors goods sector, so there is little opportunity for profitable must purchase $2 billion a day. Purchases have probably new investment there. By comparison, just before the fallen somewhat short of that figure over the past six March 2000 stock market crash when bonds faced stiff months as the dollar has depreciated by about 10 percent. competition from a soaring stock market, the expected That said, the nominal yield on long-term Treasury notes real yield on ten-year Treasury notes reached 4.5 percent. has fallen somewhat, while the yield on five-year notes has remained about stable since foreign purchases of U.S. Other Determinants of Interest Rates Treasury notes have, along with domestic purchases, kept prices of such notes stable to rising. Another determinant of interest rates on ten-year Treasury Foreign investors own a substantial portion of outnotes (and all assets) is Federal Reserve interest-rate polstanding U.S. government debt; some estimates put the icy. Since the Fed can control short-term interest rates by figure as high as 45 percent. Private and official foreign setting the federal funds rate at which banks can borrow owners of Treasury debt have been willing to increase their overnight, it also controls the rate at which an investor holdings of that debt as the supply increased. Leaving aside can borrow, using a string of short-term borrowing transforeign official purchases of Treasury securities tied to curactions, to finance the purchase and holding of a longerrency intervention (not an insignificant fact, but also not term Treasury note. one that I want to focus primarily on here), other reasons Of course such transactions carry the risk that, as the make Treasury securities attractive to private and official Fed raises the federal funds rate, the spread will be reduced. foreign holders. Indeed, the Fed did begin to raise the federal funds rate in June of this year and so far has increased the rate by 125 basis points from 1 percent to 2.25 percent. Interestingly, Unique Appeal of U.S. Government Bonds during that period the yield on ten-year Treasury notes has fallen slightly from about 4.6 percent in June to the curU.S. Treasury securities look even more attractive to forrent 4.2 percent. As the Fed has raised short-term interest eign investors as a way to store wealth than they do to

-3U.S. domestic investors. Foreign official institutions that accumulate foreign exchange reserves need to store those accumulated reserves in a market that is highly liquid and safe. It may be necessary to buy or sell securities in multi-billion dollar lots, and no other markets can accommodate, as well, transactions of such size that are simultaneously such a good store of value. The superiority of the Treasury market as a way to store wealth helps to account for the low interest rates on Treasury securities. There are other markets for government securities. Sovereign debt (the liabilities of governments) tends to represent a higher quality credit than corporate debt for the simple reason that sovereign debt in advanced industrial countries is backed by the governments power to tax in order to meet its liabilities. The catch has always been that governments may be tempted to levy an inflation tax and thereby depreciate the real value of their liabilities. Other governments are unable to collect taxes effectively and so are forced to use the inflation tax. But since the disastrous episode of the 1970s when inflation and interest rates soared, governments and central banks that have a choice have learned that low and stable inflation contributes to higher growth by virtue of reducing the real cost of raising money in stable credit markets. U.S. government debt is a superior store of wealth that is in heavy demand globally. It is a superior store of wealth because the United States government has a wellestablished tax system run by a notoriously efficient Internal Revenue Service able to raise the funds necessary to service the debts of the government, among other tasks. The sovereign portion of the attractiveness of U.S. government debt is tied to the fact that the U.S. is the worlds preeminent military power, able to effect its goals globally with that power and able to finance the activities of its military by issuing debt. This has been amply demonstrated during the War in Iraq, as the period of rising budget deficits tied to that war has produced no increase in U.S. interest rates and no attendant increase in U.S. inflation expectations. In fact, interest rates and inflation expectations have both declined over this period. Alternative sovereign debt to U.S. Treasury debt does exist, but it is simply not as attractive. Euro-denominated debt is an amalgam of the liabilities of the many governments included in the European monetary system. Outstanding euro debt may be euro-denominated liabilities of the governments of Italy, France, or Germanycountries with different long-term reputations as stewards of stable purchasing power. Beyond that, most European governments shoulder retirement and health programs, the costs of which are far more onerous than even the costs being faced by U.S. programs. Hence, the prospective borrowing needs of such governments and the temptation to pursue inflationary policies are perhaps more present in Europe than they are in the United States. Europe endures the awkward reality of one central bank and twelve treasuries in the European Monetary Union. While the central bank is earnest about maintaining hard money and stable prices, the pressures on the various European governments to fund overburdened social programs probably means that political pressure on the European Central Bank to inflate some time during the next decade will be intense. With that all said, some governments and private sector investors seeking wealth storage prefer euro-denominated assets to dollar-denominated assets, especially as the dollar has weakened against the euro. This is part of a normal market adjustment that has pushed yields on European bonds below yields on U.S. bonds as a reflection of the expected depreciation of the dollar against the euro. The other major sovereign government bond issuer Japanoffers remarkably low nominal yields. The yield on ten-year notes in Japan is about 1.3 percent, or less than a third the yield in the United States. While the yen tends to be a hard currency, such yields are artificially depressed by the fact that Japans central bank and government agencies own a large portion of Japans substantial outstanding debt. This suggests that the market for such debt is nowhere nearly as liquid as the market for U.S. Treasury debt.

U.S. Debt and Social Security Reform

Looking forward, the attractiveness of U.S. sovereign debt can be a great asset in helping to finance the transformation of Social Security from a pay-as-you-go system financed by payroll taxes to a pre-funded system. The transition will involve allowing younger participants in the Social Security system to designate some of their payroll tax payments toward the accumulation of assets that they own and can transfer to their heirs. United States sovereign debt could provide an excellent wealth storage vehicle for U.S. workers seeking to build up their own retirement nest eggs. In fact, it may be useful for the U.S. Treasury to contemplate issuing much longer-term debt as an attractive asset to offer to U.S. workers during the transition from a pay-as-you-go retirement system to a pre-funded one. During the nineteenth century, the British government

-4percent on deposits in an insolvent state banking system successfully offered consolsthat is, perpetual liabilities of are forced to chase after back-alley investments through the governmentas a means to finance its activities. The shady intermediaries raising money to fund highly risky yield on consols averaged about 2.5 to 3 percent, the longreal estate investments. They would be pleased to have the run real rate of return on capital, during periods of low opportunity to own long-term claims on the inflation. The U.S. Treasury may wish to consider Looking forward, the U.S. government paying a 4-percent rate of return. Indeed, the governments of many a large issue of consols to fund the approxiattractiveness of U.S. countries, including China, Japan, Korea, mately $2 trillion worth of transition costs Taiwan, and other Asian nations, have over ten years. It seems appropriate for the sovereign debt can found U.S. Treasury securities to be a particU.S. government to issue long-term debt to be a great asset in ularly attractive store of value and so have finance a long-term investment in the solvency of the Social Security system. Experihelping to finance the continued to buy them. The appeal of U.S. government liabilience shows that by issuing such long-term ties as a store of value has contributed to debt, the financing costs may actually be transformation of the ease with which large U.S. current lower than costs of using shorter-term debt Social Security from account deficits are financed. It could be by virtue of the large demand for long-term said that the U.S. current account deficit assets among pension and insurance compaa pay-as-you-go has continued to rise because foreign govnies that need to match long-term liabilities system financed by ernments and foreign investors will not with long-term assets. Beyond that, longpermit it to fall. The United States exports duration instruments such as consols, or payroll taxes to a superior claims on future goods or superior even fifty or one-hundred-year government pre-funded system. media for wealth storage, with U.S. govbonds, would be attractive for managers of ernment securities among the best in this mortgage portfolios by virtue of the longcategory. Americas low national saving duration of such assets. Mortgage portfolio rate is as much a testimony to the attractiveness of U.S. managers need to make rapid adjustments in the duration government liabilities as a store of value as it is a measure of their portfolios, and very long-term government liabilof U.S. imprudence. ities can make such adjustments easier. That said, conditions may change, and the terms on which foreigners are willing to finance a low U.S. Looking Ahead national saving rate may change. Indeed, if real returns on assets abroad were to rise, U.S. real interest rates Alexander Hamilton, Americas greatest Treasury secrewould rise, and the real return on U.S. government tary, observed during his effort to consolidate the debts of securities would rise. The possibility that interest rates the new republic in 1781 that a national debt, if it is not may rise in the future is another reason for the U.S. excessive, will be to us a national blessing. Hamilton government now to consider funding the transition to a understood that sovereign governments perform a service sound Social Security system with long-term debt. by issuing large stocks of debt that pay predictable interWhen all is said and done, it is the search for ways to est rates that, in turn, sustain stable purchasing power by store wealth that drives interest rates and not some hazy virtue of stable prices. A national debt of $3.5 trillion, notion of unsustainable twin deficits. Markets clear the current level, is not excessive for an $11 trillion every day. Today, everyone knows what the outlook is economy like that of the United States. Nor is an addifor U.S. inflation, issuance of Treasury securities, and tional $2 trillion in debt issued over ten years to restore economic growth relative to the same variables in the solvency to the Social Security system as the economy rest of the world. It is somewhat ironic that the plans of grows to $18 trillion. the Bush administration to place its government proThe demand for U.S. debt instruments will continue to grams for retirement and health care on an actuarially rise worldwide. Investors in emerging marketsespecially sound basis have been taken by critics as a reason for China where wealth is rising rapidlyare hungry for U.S. interest rates to rise. Fortunately, based on the funattractive ways to store wealth and are largely deprived damentals of interest rate determination, global marof such outlets by controls on capital outflows. Chinese kets know better. households that can only store wealth by earning 2.5
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