March 02, 2005

ROBERT SAMUELSON -- The Mystery of Low Interest Rates:
Among worriers, the fear is that cheap credit has created a housing "bubble.'' In the year ending in September, average U.S. home prices rose 13 percent, reports one survey. In Nevada they rose 36 percent, in California, 27 percent and in Florida, 20 percent. Higher housing prices have supported consumer spending -- people borrowed against home values -- and free-spending Americans have bolstered the U.S. and global economies. If the cycle reversed, the consequences might be grim. Falling home prices. Sickly consumption. Global slump. In the critics' story, the Fed plays the villain. It fostered artificially low mortgage and bond rates through cheap short-term credit. Hedge funds and investment banks embraced the "carry trade'': They borrowed short-term funds at 2 percent or 3 percent and invested in longer-term securities with higher rates. Pension funds and insurance companies shifted from short-term to long-term securities, because short-term interest rates were so low. The flood of money depressed rates on most bonds and mortgages. Indeed, the "spreads'' -- the gaps -- between rates on Treasury bonds and rates on "junk'' bonds and bonds of "emerging market'' countries are now at historical lows, says Diane Vazza of Standard & Poor's. But the structure of interest rates -- and hence housing -- is vulnerable to a nasty surprise and also to the Fed's present policy of raising short-term rates ..

All this attests to our economic ignorance. There are no simple rules .. to explain interest rates. My view is that low interest rates are mainly a good sign. They reflect not only low inflation but growing confidence that it will stay low. We may be reverting to the 1950s, when this was the norm. In 1959 the rate on the 10-year Treasury bond averaged 4.33 percent. This is a reassuring notion; it could also be wrong.

Posted by Greg Ransom