If you have bought a house recently, you know that interest rates are low. Interest rates across the board have been low for over a decade. Those who lived during the 1970s and early 1980s will remember the astronomical interest rates and inflation.
Former Fed Chairman Paul Volker often gets credit for lowering interest rates and inflation during the 80s. Confronted with an enormous challenge, Volker decided to turn off the credit spigot and raise interest rates. That decision was incredibly unpopular at the time. Members of both parties—including President Reagan—decried Volker and the Federal Open Market Committee’s decision.
The rate increase was intended to cut the flow of the money supply in the economy with the hope that inflation would fall and that the market would naturally return interest rates to normal.
The federal funds rate reached just below 20% in 1981 before falling below 7% at the end of Volker’s two terms as Fed Chairman. President Reagan, despite being an early critic of Volker, re-nominated him for the position in 1983.
So why are interest rates and inflation so low now?
There are many theories, but no clear consensus. The obvious proposed explanation are the actions taken by the Federal Reserve. The Fed has taken unprecedented actions since the Great Recession of 2007-2009. They have infused trillions of dollars into the economy to force down interest rates in order to encourage spending and investment. During the height of the recession, the Fed primed the credit pump and rewrote the book on how to conduct monetary policy.
Conventional economic wisdom would dictate that inflation should have risen upon the recovery because of the increase in the money supply. However, inflation has remained low.
The growth rate of the economy has also been attributed to lower interest rates. However, evidence suggests that the conventional wisdom is wrong with regards to GDP’s effect on interest rates.
New research suggests that interest rates are more closely tied to the number of hours worked and the ageing workforce. That might seem odd, but it makes sense in the abstract. Those who are nearing retirement are more likely to save because they are approaching the end of their careers. Generally speaking, increased savings lower interest rates.
Economists Lunsford and West published a research paper in which they reported the following:
“Motivated by the decline in the safe real interest rate over the last several decades, we study long-run correlations between the safe real rate and over 20 variables that have been posited to move with safe rates. We find that the safe real rate in the United States has statistically and economically important long-run correlations with aggregate labor hours and demographic variables. For most other variables, we found substantive long-run correlations in some samples and measures but not in others. Based on these results, we view demographic change as a reasonable starting point for understanding the recent secular decline in real rates. Further, we prefer labor hours growth to GDP growth or TFP growth for modeling trends in safe real rates.”
Regardless of the reasons for low interest rates, today is a good day to apply for a mortgage and borrow money.
Let’s hope that it continues long into the future.