MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

YOU DECIDE:What's going on with interest rates?

By Dr. Mike Walden
North Carolina Cooperative Extension Service

There's something going on in economics that's the counterpart to the popular culture's fascination with the Katie-Tom romance, Britney's baby and Prince William's graduation. It has the economics world abuzz, and faculty scurrying to recalibrate their models. As Federal Reserve Chairman Greenspan has termed it, it's the “conundrum” over interest rates.

The puzzle is this: Interest rates on short-term loans have been rising over the past year. But interest rates on longer-term loans haven't; in fact, they're lower today than a year ago.

As an example, look at mortgage interest rates. Short term mortgages, where the interest rate can adjust each year, are up a quarter of a percentage point from last year. But 30-year mortgage fixed rates are down almost a half percentage point. These low rates have helped continue the boom in the housing market.

This recent pattern in interest rates is unusual; in fact, some analyses show it's the only time such a pattern has occurred at this stage of the economic cycle. Typically, when the economy is growing, as it has been since the 2001 recession, interest rates rise as demand for loans improves and price inflation edges up. Indeed, the Federal Reserve has contributed to this process by ratcheting up the short-term interest rates it controls.

But the Fed doesn't control long-term interest rates. Instead, these rates are set in financial markets by participants looking several years into the future and trying to forecast economic and financial conditions.

So what's keeping long-term interest rates low? There are three alternative explanations, one with negative implications, and the other two with more positive consequences.

The negative explanation is that today's lower long-term interest rates signal an upcoming slowdown in the economy and maybe even a recession. In the past, a narrowing gap between short-term and long-term interest rates has been a good predictor of a recession. Long-term rates fall with the expectation that loan demand will drop during a recession.

The second explanation is also based on a forecast of the future economy, but here the prediction is upbeat. Long-term interest rates could be lower today because inflation is expected to be lower in the future.

To understand this logic, realize that any interest rate is made up of two parts. One is the average annual inflation rate projected over the life of the loan, and the second is a spread needed to cover other costs of making the loan. So if lenders think future inflation rates will be lower than today, long-term interest rates can fall.

These first two explanations have been standard ones in economics for explaining movements in long-term interest rates. It's really the third possible explanation that has economists talking excitedly. This answer says today's low long-term interest rates result from an abundance of savings in the world.

As in all economic markets, the interaction between the demand for loans and the supply of loanable funds determines the level of any interest rate. If loan demand increases faster than loan supply, the interest rate rises. Conversely, if loan supply increases faster than loan demand, down goes the interest rate.

As world financial markets have become more integrated, some economists think large amounts of savings generated in developing countries like China and India are effectively available for loans anywhere in the world. If so, this would especially put downward pressure on long-term interest rates. Support for this theory comes from the fact that such interest rates are relatively low all around the world.

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Dr. Mike Walden is a William Neal Reynolds Professor and extension
economist in the Department of Agricultural and Resource Economics of North
Carolina State University's College of Agriculture and Life Sciences. He
teaches and writes on personal finance, economic outlook and public policy.
His You Decide column is provided every two weeks by the Department of
Communication Services. Earlier You Decide columns are available on the Web
at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm
Related audio files are at
http://www.ces.ncsu.edu/depts/agcomm/writing/walden/index.html