The importance of low U.S. interest rates in the long run

Mention U.S. interest rates today, and the focus will almost certainly turn to the short term. The Federal Reserve is having an important debate about when to raise the federal funds rate, the central bank’s key short-term interest rate, from zero percent. The debate is incredibly important as it will help determine our expectations for the pace of U.S. economic growth, how low the nation’s unemployment rate can go, and the strength of U.S. wage growth.

With that said, it’s also helpful to step back and take a look at how the trajectory of long-term interest rates has shifted, why that has happened, and what it means for the U.S. economy.

While short-term interest rates have been incredibly low in recent years, long-term rates have been on the decline for several decades. Many economists have interpreted this as a decline in the “natural rate of interest,” or the long-run interest rate that would have the economy fully utilizing both labor and capital.

A few months ago, the President’s Council of Economic Advisers released a report looking through potential reasons why the long-term rates have declined so much. The council notes that some of the forces currently pushing down long-term rates are fleeting and should dissipate. They include the fiscal and monetary policies taken to fight the Great Recession, and the private-sector pull back on debt in the wake of that sharp 2007-2009 downturn.

But there are also forces that appear to be more permanent—forces that all result in the supply of savings growing faster than the demand for investment. (The interest rate, remember, is the “price” of loanable funds that balances the amount of funds that savers supply and that investors demand.) These forces include declining long-run productivity growth, slower population growth across the globe, and increasing savings rates by developing and now developed countries—the so-called “global savings glut.”

As University of Chicago economist John Cochrane points out, economics has a good grasp on how these different factors can push down long-term interest rates. What the field isn’t good at, however, is understanding just how much each factor contributes to the decline. Cochrane notes that the Council of Economic Advisers report cites many estimates of the different effects, and they can differ by quite a bit. While there’s strong evidence for the importance of these different effects, the precision just isn’t there. There’s a reason why the report notes that the question of why rates are so low is “one of the most difficult questions facing macroeconomists today.”

This question about the long run actually has implications for the short run as well. Vasco Cúrdia of the Federal Reserve Bank of San Francisco took a look at estimates of short-run and long-run natural rates of interest. His model shows that the current short-term rate, while zero, is still above its natural rate, which is closer to negative 2.5 percent. And looking at how the model projected the path of natural rates with previous data, Cúrdia shows that the model has expected the rate to jump up to its long-run level soon. But it hasn’t yet.

Given this uncertainty about the current natural rate, perhaps the central bank could wait to get more certainty about the health of the economy. With the long-term rate much lower, perhaps the climb won’t be that long. Waiting might not mean such a steep hike.