(idiot) Paul Krugman say 7% yield for U.S. 10-year notes sounds about right (to him).
April 20, 2004
Questions of Interest
By PAUL KRUGMAN
"Yes, the republic is in danger," a friend said. "But
what's going to happen to interest rates?" O.K., let's take
a break from politics.
Over the past two years, interest rates have been very low.
Last June the 10-year bond rate hit a 48-year low. Even
three weeks ago the rate was still below 4 percent, a level
last seen in 1963.
If the economy fully recovers - or even if investors just
think it will - interest rates will rise sharply. In its
World Economic Outlook report, to be issued tomorrow, the
International Monetary Fund urges the Federal Reserve to
prepare the economy for higher rates to "avoid financial
market disruption both domestically and abroad."
But how far will rates rise? Let's not get into Greenspan
Kremlinology, parsing the chairman's mumbles for clues
about the Fed's next move. Let's ask, instead, how much
rates will rise if and when normal conditions of supply and
demand resume in the bond market.
My calculations keep leading me to a 10-year bond
rate of 7 percent, and a mortgage rate of 8.5
percent - with a substantial possibility
that the numbers will be even higher. Current
rates are about 4.3 and 5.8 percent,respectively;
you can see why the I.M.F. is worried about
"financial market disruption."
Why 7 percent? Well, in the past 20 years the average yield
on 10-year bonds has, in fact, been about 7 percent. Why
shouldn't we think of that as the norm?
[Because we are not morons, like you ...]
Some people say that unlike past interest rates, future
interest rates won't include a premium for expected
inflation. Indeed, over the past 20 years the average
inflation rate was 3 percent, considerably higher than
recent experience. But in the first three months of 2004,
prices rose at an annual rate of more than 5 percent. That
number included soaring gasoline prices, but even the
"core" price index, which excludes food and energy, rose at
a 2.9 percent rate.
More to the point, investors expect considerable inflation
over the next 10 years. The spread between "inflation
protected" bonds, whose payments are indexed to the
Consumer Price Index, and ordinary bonds indicates an
expected inflation rate of 2.5 percent during the next
decade.
So you can't claim that interest rates will be far below
historical levels because inflation is gone. And on the
other side, we need to think about the impact of budget
deficits.
That last sentence will send the deficit apologists to
battle stations (sorry, I can't avoid politics completely).
For many years, advocates of tax cuts have insisted that
the normal laws of supply and demand don't apply to the
bond market, and that government borrowing - unlike
borrowing by families or businesses - doesn't affect
interest rates. But there's no argument among serious,
nonideological economists. For example, a textbook by
Gregory Mankiw, now the president's chief economist,
declares - in italics - that "when the government reduces
national saving by running a budget deficit, the interest
rate rises."
The Congressional Budget Office estimates this year's
structural budget deficit - what the deficit would be if
cyclical factors like a depressed economy went away - at
3.9 percent of G.D.P. That's almost twice the average
during the past 20 years. Standard estimates say this
should push up 10-year interest rates by around one
percentage point.
Finally, there's the upside risk. As I've pointed out
before, the twin U.S. budget and trade deficits would set
alarm bells ringing if we were a third world country. For
now, America gets the benefit of the doubt, but if
financial markets decide that we have turned into a banana
republic, the sky's the limit for interest rates.
Now for the obvious point: many American families and
businesses will be in big trouble if interest rates really
do go as high as I'm suggesting. That's why the I.M.F. is
urging the Fed to get the word out.
And one suspects that the fund, which, like Alan Greenspan,
tends to convey messages in code, is firing a shot across
Mr. Greenspan's bow. A number of analysts have accused Mr.
Greenspan of fostering a debt bubble in recent years, just
as they accuse him of feeding the stock bubble during the
1990's. Just two months ago, Mr. Greenspan went out of his
way to emphasize the financial benefits of adjustable-rate,
as opposed to fixed-rate, mortgages. Let's hope that not
too many families regarded that as useful advice.
Copyright 2004 The New York Times Company. |
