YOU DECIDE: What’s the meaning of super-low interest rates?

Date posted: June 8, 2012

Dr. Michael Walden is William Neal Reynolds professor of agricultural and resource economics at N.C. State University.Dr. Michael Walden is William Neal Reynolds professor of agricultural and resource economics at N.C. State University.

Media Contact: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

By Dr. Mike Walden
North Carolina Cooperative Extension

Many of us love to hear about new records being set. I particularly like major league baseball, so when a player establishes a new hitting, pitching or fielding record, I get excited.

Recently, an economic record was set. The interest rate on 10-year U.S. Treasury notes fell to under 1.5 percent, the lowest ever. U.S. Treasury notes are simply investments with the federal government that help fund the national debt. The low interest rate is telling us the federal government doesn’t have to pay much today to attract investors.

The 10-year U.S. Treasury note rate is also the benchmark for other long-term interest rates (such as for mortgage loans), so these rates are at or close to all-time lows. Interest rates on shorter-term investments are similarly low; indeed, some are almost zero.

So what do these interest rate trends mean? Are they good or bad for the broader economy and for your personal economy? Let me try to analyze these questions and let you — as always –decide.

One way to look at an interest rate is as the price of borrowing money to use now and repay later. The interest rate is the balancing lever that makes the amount of money that some people want to borrow equal to the amount of money that other people are willing to lend.

Clearly therefore, one group who benefits from low interest rates is borrowers. For anyone who has a need to borrow and can meet today’s credit standards, now may be the best borrowing opportunity — maybe ever! But credit standards have tightened, so some who want to take advantage of the low interest rates may not be able to qualify for a loan.

One entity taking advantage of today’s low interest rates is the federal government. Although the national debt has risen by almost $5 trillion since 2008, annual interest paid on the national debt has actually dropped. The reason: the decline in interest rates.

Of course, the flip side of cheap costs for borrowers is low earnings for investors in accounts like money market funds and short-term certificates of deposit. This is one reason why until recently investors have been moving money into the stock market.

Actually, there is a way for investors to make good money on interest-sensitive investments like bonds and U.S. Treasury securities when interest rates fall.

Here’s how. Let’s say you bought a 10-year U.S. Treasury note earlier this year when it paid 2 percent for $10,000. Today, new 10-year Treasury notes pay close to 1.5 percent. Since these investments can be bought and sold, your 2 percent note is more valuable than new 1.5 percent notes. In fact, in this example, you would be able to sell your 2 percent note for approximately $13,000.

Of course, to make such a deal, you had to purchase the 10-year Treasury note before the drop in interest rates. Also, you would lose money (on paper) if interest rates turned around and rose. Yet the point is that investors can make money when interest rates fall if they’re willing to take a risk of expecting such a decline, and if their expectation is correct.

What this example also shows is that to make money on interest-sensitive investments, you have to understand what moves interest rates up and down. Such an understanding will also help explain why interest rates are so low today.

As with most aspects of economics, we look to demand-side and supply-side reasons for interest rate movement. The demand-side answer to today’s low interest rates is rather simple; although consumers have begun borrowing again, total credit amounts are still below pre-recessionary levels. Consumers continue to be cautious about the economic outlook, and this caution has translated into a new frugality about personal finances.

There’s a secondary demand-side impact coming from investors. As economic worries — in particular, in Europe — have increased, investors have fled to the perceived safety of U.S. interest-sensitive investments, like the 10-year Treasury note discussed above. And when there are more buyers for such investments, the interest rate needed to attract each buyer falls.

The supply-side actions, mainly by the Federal Reserve, have also contributed to the low interest rate environment. The Federal Reserve (the Fed) wants to keep interest rates low and credit supplies plentiful to spur borrowing, spending and job creation. They try to accomplish this goal using three methods: directly lowering interest rates they control, printing money and buying interest-sensitive investments. The Fed has said they will continue these actions for the foreseeable future.

Super-low interest rates are both a plus and a minus. On the plus side, they keep borrowing costs low. But on the minus side, they are a symptom of a weak and uncertain economy. Hence, when they finally rise — and they eventually will — we may collectively cheer rather than boo, but you decide!

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The College of Agriculture and Life Sciences communications unit provides his You Decide column every two weeks. Previous columns are available at http://www.cals.ncsu.edu/agcomm/news-center/tag/you-decide

Related audio files are at http://www.cals.ncsu.edu/agcomm/news-center/category/economic-perspective/

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