The Rise and Fall of Nominal Interest Rates

With interest rates at historic lows, a recent Economic Synopses essay examined interest rate behavior over the past several decades.  

Federal Funds Rate and Treasuries

Senior Economist Fernando Martin used the figure below to show trends in the effective federal funds rate, one-year Treasuries and 10-year Treasuries.

Martin noted that the federal funds rate and the one-year Treasury yield track each other very closely. However, the 10-year Treasury followed the same basic path—low until the mid-1960s, increasing in the 1970s, peaking in the early 1980s, declining since then—but deviates notably from short-term rates for significant periods of time.

Corporate Bonds

Martin then compared the Aaa corporate bond rate with the federal funds rate and 10-year Treasuries, seen in the figure below.

The corporate bond rate more closely aligned with the 10-year Treasury rate. Martin noted: “The difference between the two rates reflects both risk and liquidity premia. Mortgage rates have similar properties.”

Inflation

The final comparison Martin made was between inflation (measured by the year-over-year percentage change in the consumer price index) and one-year Treasuries.

Martin wrote: “The rise in nominal interest rates until the early 1980s can be largely explained by an increase in inflation. Much of the subsequent steady decrease in interest rates can also be attributed to a decrease in inflation.”

He noted that the real interest rate on government bonds (or the difference between the nominal interest rate and the inflation rate) has also been trending downward. “In fact, the real rate has been significantly negative since the end of the most recent recession,” he wrote.

Why Are Real Rates Declining?

Martin pointed to three factors when discussing the decline in real rates.

Financial Development

Government bonds now largely resemble cash, so many corporations choose to hold on to them in lieu of cash or other money equivalents. Martin wrote: “This may explain why, in the current low-inflation environment, the long-term government debt in some developed countries has a negative yield.”

Flight to Safety

Safe assets have been in high demand since the financial crisis and with the development of large developing economies like China. Martin noted: “Arguably, the supply of safe assets has not kept pace with demand, which contributes to the decline in yields of government debt deemed to be safe.”

Financial Regulation

Banks and other financial intermediaries have been incentivized to hold more safe assets, thanks to increased financial regulation. Martin wrote: “These regulations have contributed to the overall growth in the demand for safe assets and, hence, the decline in their yields.”

Additional Resources

• Economic Synopses: A Perspective on Nominal Interest Rates
• On the Economy: Are Banks More Profitable When Interest Rates Are High or Low?
• On the Economy: Negative Interest Rates: A Tax in Sheep’s Clothing