For release on delivery
11:15 a.m. EST (10:15 a.m. CST)
January 7, 2017
Low Interest Rates and the Financial System
Remarks by
Jerome H. Powell
Member
Board of Governors of the Federal Reserve System
at the
77th Annual Meeting of the American Finance Association
Chicago, Illinois
January 7, 2017
Thank you for this invitation to discuss low interest rates and the financial system.
The framing of this topic raises the question of whether low interest rates have somehow
undermined the stability and functioning of the financial system. I will argue that "low
for long" interest rates have supported slow but steady progress to full employment and
stable prices, which has in turn supported financial stability. Indeed, by many measures
the U.S. financial system is much stronger than before the crisis. That said, there are
difficult tradeoffs to manage. Over time, low rates can put pressure on the business
models of financial institutions. And low rates can lead to excessive leverage and
broadly unsustainable asset prices--things that we watch carefully for and do not observe
at this point. I will begin by focusing briefly on the macroeconomic effects of low
interest rates. I will then turn to the condition of the financial system--in particular, its
interplay with low rates. As always, the views I express here today are mine alone.
Highly Accommodative Monetary Policy
The financial crisis and the Great Recession posed the most significant
macroeconomic challenges for the United States in a half-century, leaving behind high
unemployment and below-target inflation and calling for highly accommodative
monetary policies. Isolating the effects of these policies is challenging, but studies
generally show that they lowered rates across the curve and moved other asset prices as
well.1 It is even more challenging to evaluate their effects on aggregate demand. Low
rates and higher asset prices should support household and business spending and
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investment through various channels. But low rates may also perversely induce some
households to save more in order to meet their targets for retirement. And low rates have
clearly not produced a boom in corporate investment, although standard accelerator
models suggest that investment has largely been consistent with the weak pace of
economic growth. Nonetheless, there is good reason to think that low rates have
provided significant support for demand, and my view is that they have done so.2 As you
can see in slide 1, we are now close to meeting our dual mandate--a reasonable summary
statistic for the effects of policy. While growth has been frustratingly slow, employment
gains have been solid. This is a reasonably good outcome considering the scope of the
crisis and the relatively poorer performance of other major advanced economies.
Other Factors Are Holding Down Rates
There are also many factors other than monetary policy that are holding down
long-term interest rates. Long-term nominal and real rates have been declining for over
30 years. The next slide decomposes long-term nominal yields into expected future
short-term real rates, expected future inflation, and a term premium. These estimates are
based on one of the Board's workhorse term structure models.3 All three components
have contributed to the downward trend in long-term nominal yields.
The downward trend in nominal term premiums likely reflects both lower
inflation risk and the fact that, with inflation expectations anchored, nominal bonds have
become an increasingly good hedge against market risk. That has made bonds a more
- 3 -
attractive investment and reduced the term premium.4 As shown in the next slide, a
regression of the 10-year term premium on measures of 10-year inflation expectations
and a rolling beta of Treasury returns with respect to equity returns (to proxy for the
hedging value of bonds) shows that these two factors can account for a large part of the
decline in the term premium.
Regulations now require many financial institutions to hold more safe, high-
quality liquid assets, which likely has pushed down term premiums further. Global
factors may have put downward pressure on term premiums because of anxiety about the
foreign outlook, which may have increased demand for U.S. assets, or because low rates
abroad have depressed U.S. term premiums through a global portfolio balance channel.5
And real rates are quite low globally, reflecting the step-down of productivity growth
over the past 10 years as well as shifts in savings and investment demand due to
demographic change.6
The Core of the Financial System Is Much Stronger
Before turning to the interplay between low rates and the financial system, I will
simply point out that both improved risk management at the largest, most systemically
important financial institutions (SIFIs) and stronger regulation have made the core of
the system much stronger and more resilient than before the crisis.7 The SIFIs have more
4
The changing risk profile of nominal Treasury bonds can be seen from its capital asset pricing model (or
CAPM) beta, a measure of the co-movement between returns on longer-term Treasury securities and the
equity market. Figure A.1 shows that the estimated rolling beta of the 10-year Treasury note with respect
to the S&P 500 turned from positive to negative around 2000, indicating that Treasury bonds are now likely
to act as a safe haven, performing well when equity markets do poorly.
5
Figure A.2 shows the response in daily changes in 10-year U.S. Treasury yields to changes in 10-year
German bund yields around European Central Bank (ECB) monetary policy decisions since 2010. The
significantly positive regression coefficient is evidence of substantial spillovers from ECB monetary policy
to U.S. long-term yields.
6
See Rachel and Smith (2015) and Gagnon, Johannsen, and Lopez-Salido (2016).
7
See Powell (2015).
- 4 -
stable funding, hold much more capital and liquidity, are more conscious of their risks,
and are far more resolvable should they fail. Many aspects of our financial market
infrastructure, including the triparty repurchase agreement (or repo) market, central
counterparties (CCPs), and money market funds, are more robust as well.
Low Rates Can Mean Tradeoffs
So far, I have argued that low rates have supported aggregate demand and brought
us very close to full employment and 2 percent inflation; that forces other than monetary
policy have been pushing rates lower for more than 30 years; and that the core of the
financial system is now much stronger and more resilient than before the crisis. All of
that said, I would also agree that monetary policy may sometimes face tradeoffs between
macroeconomic objectives and financial stability. Indeed, it would be a divine
coincidence if that were not the case. There are times when all of these objectives are
aligned. For example, the Fed's initial unconventional policies supported both market
functioning and aggregate demand. More broadly, post-crisis monetary policy supported
asset values, reduced interest payments, and increased both employment and income. All
of these effects are likely to have limited defaults and foreclosures and bolstered the
balance sheets of households, businesses, and financial intermediaries, leaving the system
more robust.
But at times there will be tradeoffs. Low-for-long interest rates can have adverse
effects on financial institutions and markets through a number of plausible channels, as
listed on the next slide.8 After all, low interest rates are intended to encourage some risk-
8
See Adrian and Liang (2014).
- 5 -
taking.9 The question is whether low rates have encouraged excessive risk-taking
through the buildup of leverage or unsustainably high asset prices or through
misallocation of capital. That question is particularly important today. Historically,
recessions often occurred when the Fed tightened to control inflation. More recently,
with inflation under control, overheating has shown up in the form of financial excess.
Core PCE inflation remained close to or below 2 percent during both the late-1990s stock
market bubble and the mid-2000s housing bubble that led to the financial crisis. Real
short- and long-term rates were relatively high in the late 1990s, so financial excess can
also arise without a low-rate environment. Nonetheless, the current extended period of
very low nominal rates calls for a high degree of vigilance against the buildup of risks to
the stability of the financial system.
If we look at the channels listed here, the picture is mixed, but the bottom line is
that there has not been an excessive buildup of leverage, maturity transformation, or
broadly unsustainable asset prices.
Low long-term interest rates have weighed on profitability in the financial sector,
although firms have so far coped with those pressures. As shown in the next slide, net
interest margins (NIMs) for most banks have held up surprisingly well. NIMs have
moved down for the largest banks. Return on assets, shown to the right for both groups,
has recovered but remains below pre-crisis levels. Life insurers have substantially
underperformed the broader equity market since 2007, suggesting that investors see the
low-rate environment as a drag on profitability for the industry. Even so, data on asset
- 6 -
portfolios do not suggest that life insurers have increased risk-taking. The same is true
for banks. Both the regulatory environment and banks' own attitudes toward risk
following the financial crisis have helped ensure that the largest banks have not taken on
excessive credit or duration risks relative to their capital cushions.
Low rates have provided support for asset valuations--indeed, that is part of their
design. But I do not see valuations as significantly out of line with historical experience.
Equity prices have recently increased considerably, pushing the forward price-earnings
ratio further above its historical median (slide). And equity premiums (right)--the
expected return above the risk-free rate for taking equity risk--have declined but are not
out of line with historical experience.
In the nonfinancial sector, valuation pressures are most concerning when leverage
is high, particularly in real estate markets. Residential real estate valuations have been in
line with rents and household incomes in recent years, and the ratio of mortgage debt to
income is well below its pre-crisis peak and still declining. In contrast, valuations in
commercial real estate are high in some markets.10 And in the nonfinancial corporate
sector, gross leverage is high by historical standards. Low long-term rates have
encouraged corporate debt issuance at the same time that some regulations, particularly
the Volcker rule, have discouraged banks from holding and making markets in such debt.
High-risk corporate debt (the sum of high-yield bonds and leveraged loans) grew rapidly
in 2013 and 2014 (slide), although growth has declined sharply since then.11 However,
- 7 -
firms also are holding high levels of liquid assets, so net leverage is not elevated. Firms
have also lengthened their maturity profiles, and interest coverage ratios are high. As the
next slide shows, Greenwood and Hanson's measure of the share of high-yield debt in
overall issuance is at a relatively low level.12 And this debt is now held more by
unlevered investors. Overall, I do not see leveraged finance markets as posing undue
financial stability risks. And if risk-taking does not threaten financial stability, it is not
the Fed's job to stop people from losing (or making) money.
As I said, a mixed picture. Low interest rates have encouraged risk-taking and
higher leverage in some sectors and have weighed on profitability in others, but the areas
where there are signs of excess are isolated.
Conclusion
To sum up, low interest rates have supported economic activity and gradually
brought us back to full employment and 2 percent inflation. Better regulation and risk
management have so far minimized the tradeoffs between our macroeconomic objectives,
on the one hand, and financial stability, on the other. Still, a period of low rates for a
long time could present significant challenges for monetary policy. It could also put
pressure on the business models of some financial institutions. Ultimately, the only way
to get sustainably higher interest rates is to improve the broader environment for growth,
by adopting policies designed to increase productivity and potential output over the long
term--policies that are mainly outside the scope of our work at the Federal Reserve.13
- 8 -
References
Adrian, Tobias, and Nellie Liang (2014). "Monetary Policy, Financial Conditions, and
Financial Stability," Federal Reserve Bank of New York Staff Reports 690. New
York: Federal Reserve Bank of New York, September (revised December 2016),
available at https://www.newyorkfed.org/research/staff_reports/sr690.html.
Bekaert, Geert, Marie Hoerova, and Marco Lo Duca (2013). "Risk, Uncertainty and
Monetary Policy," Journal of Monetary Economics, vol. 60 (October),
pp. 771-88.
D'Amico, Stefania, Don H. Kim, and Min Wei (forthcoming). "Tips from TIPS: The
Informational Content of Treasury Inflation-Protected Security Prices," Journal of
Financial and Quantitative Analysis.
Dell'Ariccia, Giovanni, Luc Laeven, and Gustavo A. Suarez (forthcoming). "Bank
Leverage and Monetary Policy's Risk-Taking Channel: Evidence from the
United States," Journal of Finance.
Engen, Eric M., Thomas Laubach, and David Reifschneider (2015). "The
Macroeconomic Effects of the Federal Reserve's Unconventional Monetary
Policies," Finance and Economics Discussion Series 2015-005. Washington:
Board of Governors of the Federal Reserve System, January,
https://www.federalreserve.gov/econresdata/feds/2015/files/2015005pap.pdf.
Gagnon, Etienne, Benjamin K. Johannsen, and David Lopez-Salido (2016).
"Understanding the New Normal: The Role of Demographics," Finance and
Economics Discussion Series 2016-80. Washington: Board of Governors of the
Federal Reserve System, October,
https://www.federalreserve.gov/econresdata/feds/2016/files/2016080pap.pdf.
Gilchrist, Simon, and Egon Zakrajšek (2012). "Credit Spreads and Business Cycle
Fluctuations," American Economic Review, vol. 102 (June), pp. 1692-1720.
Greenwood, Robin, and Samuel G. Hanson (2013). "Issuer Quality and Corporate Bond
Returns," Review of Financial Studies, vol. 26 (June), pp. 1483-1525.
Mian, Atif, Kamalesh Rao, and Amir Sufi (2013). "Household Balance Sheets,
Consumption, and the Economic Slump," Quarterly Journal of Economics,
vol. 128 (November), pp. 1687-1726.
Powell, Jerome H. (2015). "Financial Institutions, Financial Markets, and Financial
Stability," speech delivered at the Stern School of Business, New York
University, New York, February 18,
https://www.federalreserve.gov/newsevents/speech/powell20150218a.htm.
- 9 -
Powell, Jerome H. (2016). "Recent Economic Developments and Longer-Run
Challenges," speech delivered at The Economic Club of Indiana, Indianapolis,
November 29,
https://www.federalreserve.gov/newsevents/speech/powell20161129a.htm.
Rachel, Lukasz, and Thomas D. Smith (2015). "Secular Drivers of the Global Real
Interest Rate," Bank of England Staff Working Paper 571. London: Bank of
England, December, available at
www.bankofengland.co.uk/research/Pages/workingpapers/2015/swp571.aspx.
Williams, John C. (2014). "Monetary Policy at the Zero Lower Bound: Putting Theory
into Practice," Hutchins Center Working Papers. Washington: Hutchins Center
on Fiscal and Monetary Policy, Brookings Institution, January,
https://www.brookings.edu/wp-content/uploads/2016/06/16-monetary-policyzero-lower-bound-williams.pdf.
Yellen, Janet L. (2016). "The Federal Reserve's Monetary Policy Toolkit: Past, Present,
and Future," speech delivered at "Designing Resilient Monetary Policy
Frameworks for the Future," a symposium sponsored by the Federal Reserve
Bank of Kansas City, held in Jackson Hole, Wyo., August 26,
https://www.federalreserve.gov/newsevents/speech/yellen20160826a.htm.
Figure 1: U.S. Unemployment and Inflation Gaps
Percent Percent Percent
10
Inflation Gap
(year-over-year core PCE
relative to 2% target)
8
6
4
2
0
Unemployment Gap
(relative to CBO natural
-2
rate of unemployment)
-4
Figure 2: Term-Structure Decomposition of the Nominal 10-Year Rate
Percent
10
10-Year Zero-Coupon Rate
Expected Average Real Short Rate
8
Expected Average Inflation
Term Premium
6
4
2
0
-2
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Source: Federal Reserve Board staff calculations based on Stefania D'Amico, Don H. Kim, and Min Wei (forthcoming),
"Tips from TIPS: The Informational Content of Treasury Inflation-Protected Security Prices," Journal of Financial and
Quantitative Analysis.
Figure 3: Fitting the Term Premium
Percent
4
10-Year Term Premium
3
Predicted Value (based on regression
against SPF inflation expectations and
rolling CAPM beta)
2
1
0
-1
Low Interest Rates and the Financial System
Banking Sector
•
Low rates can hurt net interest margins and may promote greater risk-taking and leverage
o
Shadow Banking Sector
•
Low rates may also encourage intermediation outside of the regulated banking sector
o
Other Financial Firms
•
Pension funds with fixed target rates or insurance companies selling products with embedded rate
o
floors will be less profitable and may take greater risks to meet their targets
• Asset Markets
Low rates may lead to a reach for yield, decreasing risk premiums
o
Nonfinancial Sector
•
Households
o

Low rates may create housing price bubbles and encourage a run-up in household debt
Nonfinancial Corporations
o
 Low rates may promote leverage and excessive risk-taking or low underwriting standards to
nonfinancial corporates
Percent of
Percent of assets
Figure 4a: Net Interest Margins Figure 4b: Return on Assets
interestearning assets (s.a.a.r)
(s.a.a.r)
5.5 2
5
CCAR Banks
1
Other Banks
4.5
0
4
3.5 -1
CCAR Banks
3
-2 Other Banks
2.5
-3
2
1.5 -4
2001 2004 2007 2010 2013 2016 2001 2004 2007 2010 2013 2016
Note: Net interest margin is equal to net interest income divided by Note: Return on assets is equal to net income divided by
average earning assets. CCAR is Comprehensive Capital Analysis and Review. average assets. CCAR is Comprehensive Capital Analysis and Review.
Source: Federal Reserve Board, Form FR Y-9C, Consolidated Financial Source: Federal Reserve Board, Form FR Y-9C, Consolidated Financial
Statements for Holding Companies. Statements for Holding Companies.
Figure 5: Equity Prices of Life Insurers versus the S&P 500
June 1, 2007 = 100
160
140
SNL Life Index S&P 500 Index
120
100
80
60
40
20
0
Figure 6a: Forward Price-to-Earnings Ratio of S&P 500 Firms Figure 6b: Equity Risk Premium
Percent
14
28
12
10
23
8
6
18
4
2
Historical Median
13
0
-2
8 -4
1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016
Note: Aggregate forward price-to-earnings ratio of S&P 500 firms. Based on expected Source: Federal Reserve Board staff projection.
earnings for 12 months ahead.
Source: Thomson Reuters Financial.
Percent,
Figure 7: Year-over-Year Growth of Real Total High-Risk Debt
annual rate
25
20
15
10
5
0
-5
2002 2004 2006 2008 2010 2012 2014 2016
Note: Total high-risk debt is the sum of speculative-grade and unrated bonds and leveraged loans. Nominal outstandings
growth is translated into real terms after subtracting the growth rate of the price deflator for nonfinancial business-sector output.
Disclaimer for S&P data: S&P and its third-party information providers expressly disclaim the accuracy and completeness of
the information provided to the Board, as well as any errors or omissions arising from the use of such information. Further, the
information provided herein does not constitute, and should not be used as, advice regarding the suitability of securities for
investment purposes or any other type of investment advice.
Source: Mergent Corporate FISD Daily Feed, Nominal Bonds Outstanding, www.mergent.com/mergent-solutions/fixed-
income-data; Standard & Poor's, Leveraged Commentary and Data (LCD).
Figure 8: Greenwood and Hanson High-Yield Share of Corporate Bond Issuance
Percent
60
50
40
30
20
10
0
1995 1998 2001 2004 2007 2010 2013 2016
Source: Robin Greenwood and Samuel G. Hanson (2013), "Issuer Quality and Corporate Bond Returns,"
Review of Financial Studies, vol. 26 (June), pp. 1483-1525; Federal Reserve Board staff calculations.
Figure A.1: CAPM Beta for the 10-Year Nominal Treasury Security
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Note: Two-year rolling regressions of the weekly excess holding returns to a 10-Year Treasury note versus the S&P
500 stock index. CAPM is capital asset pricing model.
Source: Federal Reserve Board staff calculations.
Figure A.2: Changes in 10-Year German and U.S. Yields around ECB Meetings
20
y = 0.7231x + 0.5061
15
R2 = 0.4943
10
5
Change in German Yield (basis points)
0
-20 -15 -10 -5 0 5 10 15 20
-5
-10
-15
Change in
U.S. Yield
(basis points)
-20
Note: ECB is European Central Bank.
Source: Federal Reserve Board staff calculations.
Figure A.3: Gilchrist-Zakrajsek Corporate Bond Spread and Excess Premium
Percent
9
8
7
Spread
6
Excess Bond
5
Premium
4
3
2
1
0
-1
-2
1973 1976 1979 1983 1986 1989 1993 1996 1999 2003 2006 2009 2013 2016
Source: Simon Gilchrist and Egon Zakrajsek (2012), "Credit Spreads and Business Cycle Fluctuations," American Economic Review,
vol. 102 (June), pp. 1692-1720; Federal Reserve Board staff calculations.