How Low? Too Low

John Lim

IT’S WIDELY ASSUMED that the Federal Reserve, our nation’s central bank, has two mandates: maximum employment and stable prices. But a closer look at the Federal Reserve Act of 1977 on the Federal Reserve’s very own website reveals a third mandate, namely “moderate long-term interest rates.”

Does a 1.7% yield on 10-year Treasurys and 2.15% on 30-year Treasurys count as “moderate long-term interest rates”? Since I have nothing better to do on the weekend, I headed to the Federal Reserve Bank of St. Louis’s website to see what the average long-term yields have been since the Federal Reserve Act of 1977 passed. The answer: 6.2% for the 10-year Treasury and 6.75% for the 30-year Treasury.

The Federal Reserve is doing much better on the employment front, with the unemployment rate hovering around 3.7% lately. And it certainly seems like prices are stable, with both the Fed’s favorite inflation metric and inflation expectations hovering around 1.6%. I guess two out of three isn’t bad.

But getting back to the Fed’s third mandate: Is it really a mandate and, if so, does it really matter? To answer the first question, I consulted Prof. Google. I typed “Federal Reserve and moderate long-term interest rates“ into the search box. The top five search results linked to official Federal Reserve websites. A site run by the Federal Reserve Bank of Richmond tersely states: “The third goal—’moderate long-term interest rates’—is often not explicitly discussed.” According to the Federal Reserve Bank of San Francisco, “These dual policy goals [maximum employment and low stable inflation] imply moderate long-term interest rates.” Talk about a non-mandate mandate.

It’s worth noting that the Fed has much less control over long-term interest rates than short-term rates, hence the predictive power of the yield curve. If so, why include the third mandate in the 1977 Federal Reserve Act? I suspect it was included because the 1970s were a period when inflation began to spiral out of control. This led to very high interest rates, with the 30-year Treasury eventually peaking at 15% in 1981.

If inflation and inflation expectations are under control, as they have been for decades, long-term interest rates will likely be contained. But what about excessively low long-term rates? Does the Fed have a duty to prevent long-term interest rates from getting too low?

Based on the actions of the Federal Reserve in recent years, the answer is an unequivocal “no.” The post-Great Recession quantitative easing and zero interest rate policy took aim not just at short-term rates, but also at long-term rates, dragging both lower. As recently as 2016, Ben Bernanke discussed the explicit targeting of long-term rates as a viable tool for the Fed. With a recession on the horizon and interest rates already so low, it’s certainly possible—and maybe even probable—that long-term interest rates will soon be targeted again and pushed even lower, perhaps to zero or below, with the goal of spurring economic growth.

Even if the Fed cared about its third mandate, the Fed does not operate in a vacuum. Interest rates in most other developed economies are even lower than ours. Do ultra-low interest rates across the U.S. yield curve, and negative interest rates across Europe and Japan, even matter? Doesn’t this make our burgeoning debt—sovereign, corporate and consumer—much more manageable? Aren’t lower interest rates on mortgages a win-win for consumers? Fun fact: Mortgage rates in Denmark are already negative.

Whenever something has been dormant for an eternity, it’s natural to assume it is dead. Inflation was conquered by Fed Chairman Paul Volcker in the 1980s and has been hibernating ever since. Bloomberg recently declared the death of inflation. The Fed seems obsessed with raising inflation to its 2% target, something I’ve never quite understood. Wouldn’t 1% inflation be even better than 2%?

Intent on raising inflation from the dead and stimulating the economy, central banks around the world are using more and more unconventional methods to depress rates further into negative territory. Previously the specter of inflation would have given them pause. But inflation is dead, right?

Very smart people can’t seem to agree whether we’re in a stock market bubble or a bond market bubble or perhaps a real estate bubble. It’s my belief that they’re all correct. But I’d argue the real bubble is in interest rates. Financial assets are priced according to so-called present value—the value, in today’s dollars, that we put on investment earnings we expect to receive in the future. When interest rates are depressed, present values—and hence the price of financial assets—are elevated. In other words, if we can’t earn much interest by buying bonds, a stream of future stock market dividends seems that much more valuable.

Persistently cheap money, in the form of ultra-low interest rates, leads to many unintended consequences, one of which could be the resurrection of inflation. That may seem unlikely today. But remember, what’s dormant isn’t dead—and renewed inflation could eventually lead to far higher interest rates and much lower stock prices.

John Lim is a physician who is working on a finance book geared toward children. His previous articles include Solomon on MoneyOut on a Lim and My Sentence. Follow John on Twitter @JohnTLim.

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