Byline: Robert Samuelson
Something strange happened on the way to higher interest rates: they declined . We're talking about rates on long-term mortgages and bonds. These rates truly affect the economy, because they influence housing and business investment. Most economists expected them to rise. But no. Last June rates on 30-year fixed mortgages averaged 6.29 percent; now they're about 5.7 percent. Federal Reserve chairman Alan Greenspan recently called the declines a "conundrum." Equally puzzling is whether the declines guarantee a healthy economy--or suggest a speculative "credit bubble."
To judge the weirdness, consider all the forces that should have raised rates. For starters, there's the expanding economy; that should increase credit demands. Next, there's the Fed's policy of squeezing credit supply. Since last June the Fed has raised the Fed funds rate from 1 percent to 2.5 percent. (This rate, the only one the Fed controls directly, applies to overnight loans among banks. Higher rates imply the Fed is striving to curb bank credit.) Growing credit demand meets tightening supply--rates rise. But they haven't. It's "highly unusual" for long-term interest rates to fall "despite a better economy and [Fed] tightening," says Mark Zandi of Economy.com.
But wait, there's more. Exploding federal budget deficits have also bloated credit demands. Since 2001, deficits have totaled $948 billion; and deficits are projected indefinitely. Still, Treasury bond rates have dropped. In January 2001, when Bush became president, the rate on a 10-year Treasury bond was 5.16 percent. Now, it's about 4.25 percent.
Theories abound to explain the mystery. Here are three, courtesy of economist David Wyss of Standard & Poor's. Each has flaws. Cautious companies, it's said, aren't borrowing much for new investment. True. In September the debt of nonfinancial corporations was up only 3.3 percent from a year earlier. But strong household and federal borrowing (up 9.8 percent and 9.7 percent) have offset weak business borrowing. Another theory is that foreigners have rescued us by investing huge sums in U.S. bonds and mortgages. Through September, foreigners had provided 32 percent of the money raised in U.S. credit markets in 2004, up from 14 percent in 2000. But foreign lending was also huge in 1996 (28 percent), when interest rates were higher. Finally, today's low rates may mainly reflect low inflation; lenders don't require extra compensation for the erosion of their money. True. But inflation expectations haven't changed much recently. How could they explain the latest drop in rates?
There are also gloomier …