Why are interest rates so low?
In a March 30 blog post, former Fed Chairman Ben Bernanke answered the question, “Why are interest rates so low?” Most people answer that question by saying that the Federal Reserve is keeping interest rates low. But when it comes to something as big as the world’s economy, the answer isn’t as simple as that. And according to Ben (we’re on a first-name basis), the answer isn’t purely the Federal Reserve.
He has a point. The Fed sets a benchmark interest rate and is a main force in inflation. Inflation in turn has its own influence on interest. Yet as he points out in the blog post, the Fed has little control over longer-term rates, and the rate that should be the true concern of most is the real interest rate.
What is this “real interest rate”? First you begin with the nominal rate of return. That’s the one you have before you subtract things like expenses, inflation, and taxes. The real rate of return is the nominal rate minus inflation. It is measuring how your investments are doing not in dollars but in purchasing power—how much more you can buy with the money you earned. If inflation is higher than your nominal return then you are making money, but losing purchasing power…not a good situation in the long-run.
For the economy and for you, it’s the real rate of return that matters.
Think about it. What would you rather have, a CD earning 5% or one earning 2%? The obvious answer is one earning 5%. But that is only the right answer all other things being equal. If the 5% CD is during a time of a more heated economy when inflation is running 4.5%, then the real rate of return would only be 0.5%. If the 2% CD was during cooler economic times where inflation was running only 1% then its real rate would be double that of the 5% CD. In this example, while the 5% makes more money (has a greater nominal rate of return) the 2% CD has better real rate and will allow you to buy more stuff.
Did I lose you yet? No? Good, because that was the most understandable part of Ben’s blog post. Once you get that down, it’s time to learn about the equilibrium interest rate. It is the interest rate that occurs when the demand for money in the economy equals the supply of money. Balance is generally a good thing to have, and so the Federal Reserve (which controls the money supply) tries to match the supply of money to the demand. The problem is there is no way to know just what the demand is; instead, they just look at the effects of the supply they put into the system.
This has sometimes been described as trying to drive forward by looking in the rear-view mirror. Not impossible if the road is straight, but improbable when there’s a curve ahead.
Want to know more? Just search the Internet for “Bernanke blog interest rates” and you’ll find this first blog in a series on the Brookings Institute website. We also shared this blog post on April 8 on Facebook.com/PersonalMoneyPlanning.
This article was published under the title "Bernanke explains ins, outs of rates" in the Wichita Falls Times Record News on April 26, 2015.