Third Way on Why Low Interest Rates Won't Last

Dec 7, 2012 | Budgets & Projections

It may be true currently that although our national debt has been growing rapidly, interest rates are low. This fact has led some leading economic commentators to believe that putting in place a plan to reduce the deficit is not a priority and can wait.

We've talked before about whether these interest rates will last, and in a new report Third Way's Jim Kessler, Lauren Oppenheimer, and David Hollingsworth make their case on why the prevailing low interest rates on US Treasury Bonds may be short-lived--arguing it is a result of a number of global and domestic economic conditions that will likely not last.

The report outlines five reasons why a continuation of the status quo means that the current low interest rates enjoyed by the federal government will disappear. The reasons are as follows:

1. Europe gets its act together

A temporal reason why interest rates are so low is because of the fiscal problems in Europe and the flight to safety that results. The report argues that looking at current trends, our interest rates could go up since the size of our debt obligations are almost identical to those of the EU. However, the EU has had more of a political problem since, unlike the US, it lacks strong institutional mechanisms and a robust political center to solve its problems. Thus, investors have favored US bonds over bonds in euro countries. But the authors point to this caveat:

Over the past several years, Eurozone members have been inching closer to a political solution by more fully integrating the continent—including the development of a single banking supervisor for all Eurozone countries which would help stabilize the financial sector. Serious obstacles clearly remain, but it is certainly plausible that over the next several years Europe will move to a level of integration that satisfies investors, making the bonds of European countries an attractive alternative to U.S. Treasury bonds.

2. China cuts back on buying Treasury Bonds

It is common knowledge that China is the largest foreign holder of US government debt. However, this report alludes to evidence that China is seeking to diversify its investment portfolio. Therefore, it is cutting back on US bonds and this will apply upward pressure on interest rates in the future. They explain:

The question is whether China is “hedged to wedge?” In other words, is China stuck with U.S. Treasuries because selling them would both devalue their remaining assets and appreciate their currency? Perhaps the answer can be found in this statistic: over the last year, China’s holdings of U.S. Treasuries have declined by $125 billion, or 9.8%. This could indicate that China is exploring options for a way out of its marriage with U.S. government debt.

3. Interest rates regress toward historical averages

The report points to the fact that one of the most powerful forces in the market is the tendency to regress toward the mean. It explains that over the last fifty years, the average interest rate for 10-year U.S. Treasury bonds was 6.7%, and over the last 30 years it's been 6.5%. With the current interest rate of 1.64%, they say that there is the likelihood of it regressing towards the mean sooner or later. They further write that one factor--the strength of the US economy--can at least partially explain both the low rates now and why they will not continue into the future. Once the US economy fully recovers, Treasury bonds will look less attractive as the demand for riskier assets rises.

4. QE Infinity will be finite

The most recent round of quantitative easing (QE)--the method by which the Federal Reserve buys Treasury bonds and mortgage-backed securities to keep interest rates low--does not have an end date at this point, although most people expect it would be wound down if the US economy fully recovered or was at least on a sufficiently quick path there. The report argues that if the Fed tried to continue QE after the economy fully recovers, it could significantly raise inflation expectations and cause inflation to rise to worrisome levels -- at which point the Fed would have to end its expansionary policy or accept that inflation. If they are unable to do quantitative easing (or have ended it), the Fed would largely lose its ability to affect long-term interest rates. Either way, the end result would likely be higher interest rates on Treasuries demanded by investors. They say:

If America doesn’t solve its fiscal problems, and our economy continues to limp along while other economies revive, the Federal Reserve may not be able to keep interest rates down throughout the economy. Many businesses and households could struggle to borrow at affordable rates despite low short-term interest rates and government borrowing costs. Low rates can’t force lenders and investors to part with their cash.

5. Markets won't give an early warning on problems

The report states that markets are unpredictable and cites many instances when economies have tumbled without any warnings, including Greece in early 2010. It is an unnecessary risk to give markets a reason to turn on US debt just because we do not face high rates at the moment. They conclude:

If we fail to correct our current fiscal trajectory, the markets will eventually lose faith in our ability to service our debts. Investors will require more compensation to account for the increased riskiness of U.S. Treasury bonds. And the transition could be sudden, leaving America with little room to maneuver. When investors judge that the pain it takes to solve a country’s problems is too great or political leaders to bear, they quickly head for the exits. 

The looming fiscal cliff once again presents Washington with a great opportunity to put our debt on a sustainable path. The blunt package of spending cuts and tax increases in the cliff would be a solution, but it is a reckless way to achieve the result. A smart debt plan can avoid the short-term damage of the fiscal cliff while alleviating upward pressure on interest rates over the longer term.