What ultra-low interest rates are telling us

Special to The Globe and Mail (includes correction)

Construction of the Port Mann Bridge in Surrey, B.C., in this photo from June 21, 2012. (DARRYL DYCK For The Globe and Mail)

It is no secret why short-term interest rates are very low. With the economy still operating significantly below capacity and inflation running at just 1.2 per cent -- well below the 2 per cent mid-point of the target range -- the Bank of Canada is keeping the overnight rate at 1 per cent in order to stimulate demand through cheap short-term credit.

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The puzzle is why long-term interest rates are at near record low levels. While influenced by the policy rate, long-term rates are mainly set by the market. Unlike the U.S. Federal Reserve and the Bank of England, the Bank of Canada has not engaged in quantitative easing (printing money to buy long-term securities) in order to lower long-term rates.

Nonetheless, the current yield on a Government of Canada 10 year bond is 1.7 per cent, up only slightly from a record low of 1.6 per cent earlier this year, and well below a normal range of 4-to- 5 per cent.

The current yield on a long-term 30-year Government of Canada bond is just 2.3 per cent, or 0.4 per cent real return after inflation. This is again just above the record low, and well below a normal long-term interest rate of 2 per cent to 3 per cent on top of expected inflation.

In this fiscal year the Government of Canada plans to sell up to $8-billion of very long-term bonds, and $10-to- $14-billion of 10-year bonds. Investors such as pension funds and mutual fund managers are snapping up these new securities, essentially tying up their money for very long periods of time for negligible or perhaps even negative real returns.

Why would they not simply keep their funds in cash -- earning perhaps 1 per cent -- as many corporations seem to be doing?

The most obvious answer is that the financial markets expect the economy to be so weak for so long that deflation becomes a real possibility. Some talk of a bond bubble but, as in Japan, buying even ultra-low yield long-term bonds will turn out to be a great investment if prices are falling.

The general message we get from the federal government and much of the media is that the economic recovery may be slow and gradual, but that things will slowly get better. By contrast, the bond market is saying that the risk of a long Japanese-style deflationary slump is very real.

Ultra-low long term interest rates on government bonds should also be telling us something else.

From a cost of money perspective, there has never been a better time to invest in public infrastructure projects of the kind proposed last week by the big city mayors. These have a positive rate of return and do not add to the net public debt

As former U.S. treasury secretary Larry Summers has argued, “(it)would be amazing if there were not many public investment projects with certain equivalent real returns well above zero... At any real interest rate below 1 per cent, the project pays for itself even before taking into account any Keynesian effects. This logic suggests that countries regarded as havens that can borrow long-term at a very low cost should be rushing to take advantage of the opportunity. This is a view that should be shared by those most alarmed about looming debt crises because the greater your concern about the ability to borrow in the future, the stronger the case for borrowing for the long term.”

The message to government from the bond markets is that we should avert extended stagnation tomorrow by making long-term productive investments today.

 

Andrew Jackson is Senior Policy Adviser to the Broadbent Institute and the Packer Professor of Social Justice at York University

 

Editor's note: This version corrects the dollar value of long-term bonds the government plans to sell this fiscal year.