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would more than wipe out the extra interest that he earned, even if rates remain
unchanged for five years.
Here is how the arithmetic works for an investor who rolls over ten-year bonds for the
next five years, thus earning 2% more each year than he would by investing in Treasury
bills or bank deposits. Assume that the interest rate on ten-year bonds remains
unchanged for the next five years and then rises from 2% to 5%. During those five years,
the investor earns an additional 2% each year, for a cumulative gain of 10%. But when
the interest rate on a ten-year bond rises to 5%, the bonds price falls from $100 to $69.
The investor loses $31 on the price of the bond, or three times more than he had gained
in higher interest payments.
The low interest rate on long-term Treasury bonds has also boosted demand for other
long-term assets that promise higher yields, including equities, farm land, high-yield
corporate bonds, gold, and real estate. When interest rates rise, the prices of those
assets will fall as well.
The Fed has pursued its strategy of low long-term interest rates in the hope of stimulating
economic activity. At this point, the extent of the stimulus seems very small, and the risk
of financial bubbles is increasingly worrying.
The US is not the only country with very low or negative real long-term interest rates.
Germany, Britain, and Japan all have similarly low long rates. And, in each of these
countries, it is likely that interest rates will rise during the next few years, imposing losses
on holders of long-term bonds and potentially impairing the stability of financial
institutions.
Even if the major advanced economies current monetary strategies do not lead to rising
inflation, we may look back on these years as a time when official policy led to individual
losses and overall financial instability.
the total nominal interest rate to more than 4%, even if expected inflation remains at just
2%.
The interest rate on long-term bonds has been kept abnormally low in the past few years
by the Federal Reserves unconventional monetary policy of buying massive amounts of
Treasury bonds and other long-term assets so-called quantitative easing (QE) and
promising to keep short-term rates low for a considerable period. Fed Chairman Ben
Bernankes announcement in May that the Fed would soon start reducing its asset
purchases and end QE in 2014 caused long-term interest rates to jump immediately.
Although Bernankes announcement has focused markets on exactly when this tapering
will begin and how rapidly it will proceed, these decisions will not affect the increased
level of rates a year or two from now.
The promise to keep the overnight interest rate low for an extended period was intended
to persuade investors that they could achieve higher returns only by buying long-term
securities, which would drive up these securities prices and drive down their yields. But
the current version of this promise not to raise the overnight interest rate until the
unemployment rate drops below 6.5% no longer implies that short-term rates will
remain low for an extended period.
With the unemployment rate currently at 7.4% having fallen nearly a full percentage
point in the last 12 months markets can anticipate that the 6.5% threshold could be
reached in 2014. And the prospect of rising short-term rates means that investors no
longer need to hold long-term bonds to achieve a higher return over the next several
years.
Although it is difficult to anticipate how high long-term interest rates will eventually rise,
the large budget deficit and the rising level of the national debt suggest that the real rate
will be higher than 2%. A higher rate of expected inflation would also cause the total
nominal rate to be greater than 5%.
Todays investors may not recall how much interest rates rose in recent decades. The
interest rate on ten-year Treasuries increased from about 4% in the mid-1960s to 8% in
the mid-1970s and 10% in the mid-1980s. It was only at the end of the 1970s that the
Fed, under its new chairman, Paul Volcker, tightened monetary policy and caused
inflation to fall. But, even after disinflation in the mid-1980s, long-term interest rates
remained relatively high. In 1985, the interest rate on ten-year Treasury bonds was 10%,
even though inflation had declined to less than 4%.
The greatest risk to bond holders is that inflation will rise again, pushing up the interest
rate on long-term bonds. History shows that rising inflation is eventually followed by
higher nominal interest rates. It may therefore be tempting to invest in inflation-indexed
bonds, which adjust both principal and interest payments to offset the effects of changes
in price growth. But the protection against inflation does not prevent a loss of value if real
interest rates rise, depressing the value of the bonds.
The relatively low interest rates on both short-term and long-term bonds are now causing
both individual investors and institutional fund managers to assume duration risk and
credit-quality risk in the hope of achieving higher returns. That was the same risk strategy
that preceded the financial crisis in 2008. Investors need to recognize that reaching for
yield could end very badly yet again.
Commercial banks are required to hold reserves equal to a share of their checkable
deposits. Since reserves in excess of the required amount did not earn any interest from
the Fed before 2008, commercial banks had an incentive to lend to households and
businesses until the resulting growth of deposits used up all of those excess reserves.
Those increased deposits at commercial banks were, by definition, an increase in the
relevant stock of money.
An increase in bank loans allows households and businesses to increase their spending.
That extra spending means a higher level of nominal GDP (output at market prices).
Some of the increase in nominal GDP takes the form of higher real (inflation-adjusted)
GDP, while the rest shows up as inflation. That is how Fed bond purchases have
historically increased the stock of money and the rate of inflation.
The link between Fed bond purchases and the subsequent growth of the money stock
changed after 2008, because the Fed began to pay interest on excess reserves. The
interest rate on these totally safe and liquid deposits induced the banks to maintain
excess reserves at the Fed instead of lending and creating deposits to absorb the
increased reserves, as they would have done before 2008.
As a result, the volume of excess reserves held at the Fed increased dramatically from
less than $2 billion in 2008 to $1.8 trillion now. But the new Fed policy of paying interest
on excess reserves meant that this increased availability of excess reserves did not lead
after 2008 to much faster deposit growth and a much larger stock of money.
The size of the broad money stock (known as M2) grew at an average rate of just 6.2% a
year from the end of 2008 to the end of 2012. While nominal GDP generally rises over
long periods of time at the same rate as the money stock, with interest rates very low and
declining, households and institutions were willing to hold more money relative to total
nominal GDP after 2008. So, while M2 grew by more than 6%, nominal GDP grew by just
3.5% and the GDP price index rose by only 1.7%.
So it is not surprising that inflation has remained so moderate indeed, lower than in any
decade since the end of World War II. And it is also not surprising that quantitative easing
has done so little to increase nominal spending and real economic activity.
The absence of significant inflation in the past few years does not mean that it wont rise
in the future. When businesses and households eventually increase their demand for
loans, commercial banks that have adequate capital can meet that demand with new
lending without running into the limits that might otherwise result from inadequate
reserves. The resulting growth of spending by businesses and households might be
welcome at first, but it could soon become a source of unwanted inflation.
The Fed could, in principle, limit inflationary lending by raising the interest rate on excess
reserves or by using open-market operations to increase the short-term federal funds
interest rate. But the Fed may hesitate to act, or may act with insufficient force, owing to
its dual mandate to focus on employment as well as price stability.
That outcome is more likely if high rates of long-term unemployment and
underemployment persist even as the inflation rate rises. And that is why investors are
right to worry that inflation could return, even if the Feds massive bond purchases in
recent years have not brought it about.
minimum core of their portfolios in a form that can be used in the traditional foreignexchange role, most of their portfolios will respond to their perception of different
currencies risks.
In short, the US no longer has what Valry Giscard dEstaing, as Frances finance
minister in the 1960s, accurately called the exorbitant privilege that stemmed from
having a reserve currency as its legal tender.
But some argue that, even if the dollar is not protected by being a reserve currency, it is
still safer than other currencies. If investors dont want to hold euros, pounds, or yen,
where else can they go?
That argument is also false. Large portfolio investors dont put all of their funds in a single
currency. They diversify their funds among different currencies and different types of
financial assets. If they perceive that the dollar and dollar bonds have become riskier,
they will want to change the distribution of assets in their portfolios. So, even if the dollar
is still regarded as the safest of assets, the demand for dollars will decline if its relative
safety is seen to have declined.
When that happens, exchange rates and interest rates can change without assets being
sold and new assets bought. If foreign holders of dollar bonds become concerned that the
unsustainability of Americas situation will lead to higher interest rates and a weaker
dollar, they will want to sell dollar bonds. If that feeling is widespread, the value of the
dollar and the price of dollar bonds can both decline without any net change in the holding
of these assets.
The dollars real trade-weighted value already is more than 25% lower than it was a
decade ago, notwithstanding the problems in Europe and in other countries. And, despite
a more competitive exchange rate, the US continues to run a large current-account
deficit. If progress is not made in reducing the projected fiscal imbalances and limiting the
growth of bank reserves, reduced demand for dollar assets could cause the dollar to fall
more rapidly and the interest rate on dollar securities to rise.
important, they have put talented people in charge of the process. The rest of the world
should hope that they succeed.
This outlook for the current-account balance does not depend on what happens to the
renminbis exchange rate against other currencies. The saving-investment imbalance is
fundamental, and it alone determines a countrys external position.
But the fall in domestic saving is likely to cause the Chinese government to allow the renminbi
to appreciate more rapidly. Higher domestic consumer spending would otherwise create
inflationary pressures. Allowing the currency to appreciate will help to offset those pressures
and restrain price growth.
A stronger renminbi would reduce the import bill, including prices for oil and other production
inputs, while making Chinese goods more expensive for foreign buyers and foreign goods
more attractive to Chinese consumers. This would cause a shift from exports to production for
the domestic market, thereby shrinking the trade surplus, in addition to curbing inflation.
Chinas trade surplus and the renminbis exchange rate were high on the list of topics that
President Hu Jintao and US President Barack Obama discussed when Hu visited Washington
earlier this month. The Americans are eager for China to reduce its surplus and allow its
currency to appreciate more rapidly. But they should be careful what they wish for, because a
lower surplus and a stronger renminbi imply a day when China is no longer a net buyer of US
government bonds. The US should start planning for that day now.
All of this will mean a reduction in national saving and an increase in spending by households
and the Chinese government. China now has the worlds highest saving rate, probably close
to 50% of its GDP, which is important both at home and globally, because it drives the
countrys current-account surplus.
A country that saves more than it invests in equipment and structures (as China does) has the
extra output to send abroad as a current-account surplus, while a country that invests more
than it saves (as the United States does) must fill the gap by importing more from the rest of
the world than it exports. And a country with a current-account surplus has the funds to lend
and invest in the rest of the world, while a country with a current-account deficit must finance
its external gap by borrowing from the rest of the world. More precisely, a countrys currentaccount balance is exactly equal to the difference between its national saving and its
investment.
The future reduction in Chinas saving will therefore mean a reduction in Chinas currentaccount surplus and thus in its ability to lend to the US and other countries. If the new
emphasis on increased consumption shrank Chinas saving rate by 5% of its GDP, it would
still have the worlds highest saving rate. But a five-percentage-point fall would completely
eliminate Chinas current-account surplus. That may not happen, but it certainly could happen
by the end of the five-year plan.
If it does, the impact on the global capital market would be enormous. With no currentaccount surplus, China would no longer be a net purchaser of US government bonds and
other foreign securities. Moreover, if the Chinese government and Chinese firms want to
continue investing in overseas oil resources and in foreign businesses, China will have to sell
dollar bonds or other sovereign debt from its portfolio. The net result would be higher interest
rates on US and other bonds around the world.
Whether interest rates do rise will also depend on how US saving and investment evolves
over the same period. Americas household saving rate has risen since 2007 by about 3% of
GDP. Corporate saving is also up. But the surge in the government deficit has absorbed all of
that extra saving and more.
Indeed, the only reason that Americas current-account deficit was lower in 2010 than in
previous years is that investment in housing and other construction declined sharply. If
Americans demand for housing picks up and businesses want to increase their investment, a
clash between Chinas lower saving rate and a continued high fiscal deficit in the US could
drive up global interest rates significantly.