American borrowing costs keep plunging, and that is signaling something important: Some of the basic assumptions of the most influential economic technocrats in the land are, for the time being at least, off base.
Ten-year U.S. Treasury bonds are yielding only 1.95%, down from around 2.4% in May and 3.2% as recently as November. Global investors are essentially flinging money at any creditworthy entity that might wish to borrow. Rates on home mortgages, corporate bonds and the debt of countries around the world have been falling as well.
This is terrific news if you are a homeowner thinking of refinancing your mortgage or a chief financial officer about to roll over some of your company’s bonds. It is terrible news if you want to see faster global economic growth in the years ahead. Lower long-term rates imply that investors expect even lower growth and inflation than had seemed probable just weeks ago.
But there is a bigger lesson in falling long-term interest rates — especially coming at this point in the economic cycle, amid this mixture of tax and spending policies coming from Washington.
Consider some of the assumptions that are embedded in the economic models of the two government agencies most respected for their independence and technical expertise: the Congressional Budget Office and the Federal Reserve.
When the CBO projects how legislation will affect the economy, it assumes that when the government borrows more, higher deficits will cause interest rates to rise, crowding out investment by the private sector.
Generations of college economics students have been taught that this is simply how things work, and the reason that countries should avoid running large budget deficits. But the logic just isn’t holding up right now.
For example, in the spring of 2018, when the CBO modeled tax cuts and spending increases that had been agreed to the preceding winter, it forecast that higher deficits would result in higher interest rates: 3.7% on 10-year Treasury bonds in 2019.
That is 1.75 percentage points higher than actually was the case Wednesday.
In 2015, the budget deficit was 2.4% of GDP, a number that is on track to rise to 4.2% this year. Yet the 10-year bond yield is now comfortably below its average level in 2015, which was 2.14%.
Low interest rates worldwide are probably a factor. Global investors find Treasury bonds appealing because they offer better returns than equivalent securities in Europe or Japan, even after the recent drop in rates. The implication is that higher deficits haven’t come with the costs that economic orthodoxy predicted.
Meanwhile, the Federal Reserve has raised interest rates — albeit in fits and starts — since the end of 2015 based on its own form of economic orthodoxy. It’s the idea that as unemployment falls, eventually it will cause an outburst of inflation — so part of the job of a central bank is to raise interest rates pre-emptively to slow the economy in time to prevent unemployment from falling too far.
At the meeting in December 2015 where Fed officials first raised rates, for example, their consensus projection was that the longer-term level of the unemployment rate was 4.9% and that they would need to raise interest rates to 3.5% by now to keep the economy in balance and forestall inflation.
The actual results have undermined those assumptions. The unemployment rate has fallen to 3.6%. But the inflation rate has remained persistently below the 2% the Fed aims for. If anything, the growth rate of workers’ wages has been slowing in recent months. That’s important because higher wage growth is, in the traditional theory, the mechanism by which a tight labor market fuels overall inflation.
Moreover, the movements in bond markets the past few weeks suggest that very low inflation is likely to be the norm indefinitely, despite the low jobless rate. Prices of inflation-protected bonds versus regular bonds imply that consumer prices will rise only 1.66% a year over the coming decade.
And rather than raise rates to 3.5%, as Fed officials in 2015 envisioned, they have raised their main interest rate target to only about 2.4% — and now are poised to cut it in the near future as the world economy starts to creak.
Global factors are a major driver of the disconnect. The U.S. economy has been relatively strong in recent years compared with Europe and Japan, but the slow growth in much of the world has acted on a brake on how much the Fed can raise rates and how much inflation can emerge.
When rates in the United States rise too high relative to other major economies, the dollar strengthens on global currency markets, which then weakens American export industries. Tighter money in the United States can send ripples to emerging markets where many companies borrow in dollars — meaning that when the Fed raises rates, it can slow the entire global economy, and worsen already powerful deflationary forces.
There have been moments over the past few years when the old economic rules were reasserting themselves — when it seemed that high deficit spending really was starting to push interest rates higher, and when low unemployment was starting to fuel a cycle of higher wages and prices.
They have turned out to be false dawns. A set of rules that seemed to describe how the world works as recently as 2007 seems to have given way to something different. We now have a complex set of challenges with, at their core, an aging work force and other shifts that can’t be easily turned around.
The first step, though, is for all those in a position to influence economic policy to ask deep questions about whether what they learned in a college economics classroom all those years ago might no longer be so.