Sunday, February 21, 2016

Why are real interest rates so low?

Real interest rates (the nominal interest rate minus the inflation rate) have fallen about 450 basis points (4.5%) since 1985.

If we model real interest rates as the "price" of saving, then we can examine changes in the demand for saving and the supply of saving to see whether we can  account for the shift.  The demand for saving is determined by everyone who wants to borrow now (to invest), and the supply of saving is determined by everyone who wants to save now (to consume later).

The supply of savings has increased "due to demographic forces, higher inequality and to a lesser extent the glut of precautionary saving by emerging markets." On the demand side, "desired levels of investment have fallen as a result of the falling relative price of capital, lower public investment, and due to an increase in the spread between risk-free and actual interest rates."

In other words more people want to save (increase in supply) but fewer investors want to invest (decrease in demand).  Both result in a lower "price" of saving.

Because the return to saving is lower, savers should expect to earn less.  This has enormous implications for the defined-benefit pension plans that characterize government pensions.  In particular, these pension assume that they will earn 7-8% (nominal), and make payouts based on this assumption.  If pension funds earn less, then there will not be enough money to go around when the pensioners eventually retire.


  1. Maybe the U.S. needs a socialist President…at least for a while

    Dr. Froeb,

    Your post is both compelling and frightening. However, both of these adjectives have caused me – a Republican since the age of 18 – to consider the benefits of “seasoning” the U.S. government with a bit of socialism.

    Though there are many factors that have gotten us to where we are today, like massive amounts of Government debt combined with the stagnation of real wage growth and the widening of the gap between the upper and lower classes, the mess we currently find ourselves in has largely been perpetrated by Central Bank policies in the U.S. and Europe. So perhaps new Central Bank tools and a shift in U.S. Government thinking could help us to get out of the mess.
    The continuation of low real interest could have a negative effect on employment rate since the low real interest rates will have a material impact on pensions and the ability of workers to retire which will create demand for new employees. So, in order to fortify future pension payouts, the Central Bank could raise interest rates but this could negatively affect job growth and increase unemployment. It seems that increasing the demand for more workers through government programs like improving and expanding infrastructure, would be the impetus for increasing wages that could support higher interest rates thereby fortifying pension payouts and making room in the workforce for new employees entering the workforce.

    As we all witnessed with the fall of Communist regimes during the 1990’s Socialism is not a long-term solution but it can be help change the situation we’ve gotten ourselves into.

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  3. Dr. Froeb,
    I took particular interest in your post entitled “Why are real interest rates so low?” and your observation about the relationship with defined-benefit pensions for government. I reside in New York State and our State Comptroller is the sole trustee of the two state pensions systems. As you noted, these pensions typically assume a seven or eight percent rate of return, even though that has not been the norm of late. It’s particularly interesting how giving this much power to one individual – with a fiduciary responsibility to current and future beneficiaries, while also serving in an elected capacity with inherent political interests – has not been reevaluated. Individual investment decisions are sometimes questionable which should lead to questions about the possible motivations of those decisions. Instead, the Comptroller continues to anticipate unrealistic returns and – when politically acceptable – adjusts the contribution rates of participating entities (e.g. municipalities). I agree with your previous recommendation for introducing a defined contribution option. In NY State, professors in the State University system are given an option between one or the other, but that is presently the only carve-out for non-authority employees and, because of political pressures, there appears to be little appetite to expand that option.

  4. Interest Rates and Home Buying in 2016

    I am in the middle of purchasing a home, and it is incredible how fast the interest rates are changing. On the morning we went to lock in our interest rate, it was 3.75%. By the time we met with our mortgage consultant, it had dropped to 3.625%, so we locked in. By that same evening, the interest rate was back up to 3.75%. Several factors affect mortgage rates, including inflation, economic growth, monetary policy, global factors, 10-year treasury yield, and the housing market. Obviously there are home markets where the price of a houses are increasing and pricing some people out of the ownership market. However, because mortgage rates are so low, we can expect more people to purchase homes because of the cheap cost of borrowing money.

    Mortgage rates are largely affected by the Federal Reserve, which seeks to control inflation by setting short-term interest rates, which the market interprets to determine long-term interest rates, like Mortgages. According to a December article on CNN Money, “The Federal Reserve is widely expected to begin increasing interest rates soon, which means the window for record low mortgage rates is closing” (Vasel, 2015). The Federal Reserve did increase the discount rate by .25%, but interest rates are still extremely low, making it easier to borrow money. And as the market tumbles, mortgage interest rates keep dropping and are now hovering below 4%. Our mortgage consultant event said she was surprised the rate dropped below 4%.

    Vasel, K. (December 4, 2015). 4 Reasons 2016 is the year to buy a home. CNN Money.

  5. “Why has the price of oil been dropping so fast? Why now? This a complicated question, but it boils down to the simple economics of supply and demand. United States domestic production has nearly doubled over the last several years, pushing out oil imports that need to find another home. Saudi, Nigerian and Algerian oil that once was sold in the United States is suddenly competing for Asian markets, and the producers are forced to drop prices. Canadian and Iraqi oil production and exports are rising year after year. Even the Russians, with all their economic problems, manage to keep pumping. On the demand side, the economies of Europe and developing countries are weak and vehicles are becoming more energy-efficient. So demand for fuel is lagging a bit. The latest drop in energy prices — regular gas nationally now averages around $1.76 a gallon, roughly down about 43 cents from the same time a year ago — is also disproportionately helping lower-income groups, because fuel costs eat up a larger share of their more limited earnings. Households that use heating oil to warm their homes are also seeing savings. For starters, oil-producing countries and states. Venezuela, Nigeria, Ecuador, Brazil and Russia are just a few petrostates that are suffering economic and perhaps even political turbulence. Chevron, Royal Dutch Shell and BP have all announced cuts to their payrolls to save cash, and they are in far better shape than many smaller independent oil and gas producers. States like Alaska, North Dakota, Texas, Oklahoma and Louisiana are facing economic challenges. There has also been an uptick in traffic deaths as low gas prices have translated to increased road travel. And many young Saudis have seen cushy jobs vanish.”

    The oil prices and the consequences on profitability of the many countries who rely on revenue from productions shows the consequences according to Froeb when “firms…. fortunes are tied closely to the industry in which they compete”. Pricing structure for sellers is usually determined by demand — as Froeb states “how much they are willing to sell for” This is usually opposite of demand curve as competition among sellers push prices down, therefore in the oil industry due to the competition and overproduction has pushed prices down. Decline in demand for oil outside of the United States, due to the US making more oil for itself has caused a decline in demand from other countries and has also contributed to the price drop…

    Retrieved from:

  6. Normal interest rates and real inflation-adjusted rates are historically low. Historically, economists believe that monetary policy cannot affect real interest rates over an extended period of time. If the central bank’s rates are below the demand of private markets, then there should be high inflation. That’s what makes the current economy even more confusing. To add to that, the ending of QE by the Fed had a relatively small effect on interest rates.

    In 2005, former Fed chair Ben Bernanke introduced the idea of the “savings glut,” in which developing countries, such as China, are saving more than investing. The excess capital inflow to the US has reduced borrowing costs. Since the “Great Recession,” saving in the US has also increased for both households and corporations. The fear of a slowing economy and a decreased demand for loans has led to the current economic situation. Long term, the decrease in the global population growth along with an increase in technological disruption means that there will be lower interest rates longer.


    Smith, N. (2015, October 20). Get used to it. Low rates are here to stay. . Retrieved from BloombergView:

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