Why are Interest Rates So Low?

A month ago, I posted a little piece at The Beacon to raise some questions about the so-called credit crunch. You boys and girls should note that this expression is not a technical term in economic science, but rather an idiom that journalists and financial pundits toss around. In any event, for my trouble, I received a certain amount of mockery and insult in the blogosphere; serves me right, no doubt, for being such an obvious idiot. What none of my mockers and insulters saw fit to give me, however, was an answer to the question I had raised: if there is a credit crunch, why have we not seen a substantial increase in interest rates across the board?

From the discussion I provoked and from my additional reading and sifting of financial-market data, however, I have made some progress toward an answer, or, at least, part of an answer.

It seems that during the past year or so, credit has become harder to get for the least creditworthy would-be borrowers. Terms have been tightened, and the riskiest demanders have been cut off entirely. Financial institutions are trying to repair their damaged balance sheets, which in many cases still carry assets acquired during the mania of 2002-2005 whose values will eventually have to be written down or written off completely. Today’s motto seems to be, No more deadbeats, m’ lady. Why lenders have resorted to this approach, rather than adjusting the interest rates they require from higher-risk borrowers remains unclear to me. It seems fairly clear, however, that this stringency in the lowest echelon of borrowers is what is being called a credit crunch in the financial press and blogosphere. (Incidentally, it does not follow that one ought to decry this phenomenon, given that many of the riskiest borrowers who received loans in 2002-2006 ought never to have been accommodated in the first place, and wouldn’t have been if the lenders, especially the mortgage lenders, had kept their heads and done their jobs properly.)

Even if one grants the foregoing observations, however, many puzzles remain in today’s financial markets. For example, the Treasury’s inflation-indexed notes, which yielded between 2 percent and 3 percent in 2006 and most of 2007, experienced precipitous yield declines in late 2007 and early 2008, and this year until recently their yields were in the neighborhood of zero; at times, the yield was negative. Bizarre.

Yields on 1-month AA nonfinancial commercial paper also fell sharply at the same time, from more than 5 percent during most of 2006 and 2007 to 2 percent recently. Needless to say, a nominal interest rate of 2 percent at present implies a substantially negative real rate of interest, because the rate of inflation is well in excess of 2 percent–indeed, according to the official consumer price index, it was 5.6 percent between July 1, 2007 and July 1, 2008. Why would a bank lend to a business if it expected a negative 3-4 percent rate of return on the loan?

The bank prime loan rate also fell tremendously from more than 8 percent in most of 2006 and 2007 to 5 percent recently. Again, with inflation in the neighborhood of 5 percent, banks are now lending to their best customers with an expected real rate of return of zero. Why?

Note that it won’t do to say that lenders failed to anticipate the rate of inflation, because the inflation-indexed Treasury notes have also been yielding zero or less this year until recently.

Interest rates on 30-year conventional mortgages have risen this year, but even now they stand at only around 6.5 percent, which is less than the nominal peaks they reached in 2006 and 2007, and almost certainly lower in real terms, because the rate of inflation has increased lately.

Moody’s seasoned Aaa corporate bonds have yielded somewhat more of late, reaching about 5.7 percent recently, but, again, this nominal rate is barely a positive real rate. Yields of seasoned Baa corporate bonds have risen somewhat more, and now stand at about 7.3 percent. But when inflation is running at 5-6 percent, that’s pretty cheap money for corporations with a Baa rating.

As the Fed has lowered its fed funds target rate to 2 percent since late last year, the rate of growth of the money stock has picked up for both the MZM and the M2 measure, at least until the past few months, when the growth slowed substantially. Still, this monetary (mis)management does not seem adequate to explain the prevalence of real interest at a zero or even a negative rate in so many parts of the financial markets. So, although the financial bottom feeders may be experiencing a credit crunch, there is evidently extremely ample credit for the more creditworthy demanders, so ample that they are borrowing at what promises to be no real cost at all. Go figure.