Ben S Bernanke: Long-term interest rates
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve
System, at the Annual Monetary/Macroeconomics Conference "The past and future of
monetary policy", sponsored by the Federal Reserve Bank of San Francisco, San Francisco,
California, 1 March 2013.
* * *
I will begin my remarks by posing a question: Why are long-term interest rates so low in the
United States and in other major industrial countries?
At first blush, the answer seems obvious: Central banks in those countries are pursuing
accommodative monetary policies to boost growth and reduce slack in their economies.
However, while central banks certainly play a key role in determining the behavior of
long-term interest rates, theirs is only a proximate influence. A more complete explanation of
the current low level of rates must take account of the broader economic environment in
which central banks are currently operating and of the constraints that that environment
places on their policy choices.
Let me start with a brief overview of the recent history of long-term interest rates in some key
economies. Chart 1 shows the 10-year government bond yields for five major industrial
countries: Canada, Germany, Japan, the United Kingdom, and the United States. Note that
the movements in these yields are quite correlated despite some differences in the economic
circumstances and central bank mandates in those countries. Further, with the notable
levels
exception of Japan, the of the yields have been very similar - indeed, strikingly so,
with long-term yields declining over time and currently close to 2 percent in each case. The
similar behavior of these yields attests to the global nature of the economic and financial
developments of recent years, as well as to the broad similarity in how the monetary
policymakers in the advanced economies have responded to these developments. Of
course, Japanese yields are clearly a case apart, as Japan has endured an extended period
of deflation, while inflation in the other four countries has been positive and generally close to
the stated objectives of the monetary authorities. But even Japanese yields have shown
some tendency to fluctuate along with other benchmark yields, and they have also declined
over the period shown.
In my comments, I will delve more deeply into the reasons why these long-term interest rates
have fallen so low. This examination may be useful both for understanding the current stance
of policy and also for thinking about how rates may evolve. In short, we expect that as the
economy recovers, long-term rates will rise over time to more normal levels. A return to more
normal conditions in financial markets would, of course, be most welcome. Many
commentators have noted, however, that both an extended period of low rates and the
transition back toward normal levels may pose risks to financial stability. In the final portion of
my remarks, I will discuss some aspects of how the Federal Reserve is approaching these
risks.
Why are long-term interest rates so low?
So, why are long-term interest rates currently so low? To help answer this question, it is
useful to decompose longer-term yields into three components: one reflecting expected
inflation over the term of the security; another capturing the expected path of short-term real,
or inflation-adjusted, interest rates; and a residual component known as the term premium.
Of course, none of these three components is observed directly, but there are standard ways
of estimating them. Chart 2 displays one version of this decomposition of the 10-year U.S.
Treasury yield based on a term structure model developed by Federal Reserve staff.1 The
broad features I will emphasize are similar to those found by other authors using a variety of
methods.2
All three components of the 10-year yield have declined since 2007. The decomposition
attributes much of the decline in the yield since 2010 to a sharp fall in the term premium, but
the expected short-term real rate component also moved down significantly. Let's consider
each component more closely.
The expected inflation component has drifted gradually downward for many years and has
become quite stable. In large part, the downward trend and stabilization of expected inflation
in the United States are products of the increasing credibility of the Federal Reserve's
commitment to price stability. In January 2012, the Federal Open Market Committee (FOMC)
underscored this commitment by issuing a statement - since reaffirmed at its January 2013
meeting - on its longer-run goals and policy strategy, which included a longer-run inflation
target of 2 percent.3 The anchoring of long-term inflation expectations near 2 percent has
been a key factor influencing long-term interest rates over recent years. It almost certainly
helped mitigate the strong disinflationary pressures immediately following the crisis. While I
have not shown expected inflation for other advanced economies, the pictures would be very
similar - again, except for Japan.
With the expected inflation component of the 10-year rate near 2 percent and the rate itself a
bit below 2 percent recently, it is clear that the combination of the other two components
- the expected path of short-term real interest rates and the term premium - must make a
small net negative contribution.
The expected path of short-term real interest rates is, of course, influenced by monetary
policy, both the current stance of policy and market participants' expectations of how policy
will evolve. The stance of monetary policy at any given time, in turn, is driven largely by the
economic outlook, the risks surrounding that outlook, and at times other factors, such as
whether the zero lower bound on nominal interest rates is binding. In the current
environment, both policymakers and market participants widely agree that supporting the
U.S. economic recovery while keeping inflation close to 2 percent will likely require real
shortterm rates, currently negative, to remain low for some time. As shown in chart 2, the
expected average of the short-term real rate over the next 10 years has gradually declined to
near zero over the past few years, in part reflecting downward revisions in expectations
about the pace of the ongoing recovery and, hence, a pushing out of expectations regarding
how long nominal short-term rates will remain low.4
As the persistence of the effects of the crisis have become clearer, the Federal Reserve's
communications have reinforced the expectation that conditions are likely to warrant highly
1
Estimates are based on the model of D'Amico, Kim, and Wei (2010). That model employs the "arbitrage-free"
term structure framework and jointly models real yields, nominal yields, and inflation as functions of four
underlying latent factors. Historical data on nominal yields, real yields, and inflation can be used to estimate
these underlying factors and the relationship of real and nominal yields to the factors. Based on this
information, the model can be used to produce estimates of the components of nominal yields shown in chart
2. Note that inflation in chart 2 is measured by the consumer price index; inflation measured by this index is
close to but on average slightly higher than inflation as measured by the price index for personal consumption
expenditures, the measure to which the Federal Open Market Committee's 2 percent inflation objective refers.
2
For example, this decomposition as estimated based on expectations as reported in the Blue Chip Financial
Forecasts gives broadly similar results, as do many standard term structure models.
3
See Statement on Longer-Run Goals and Monetary Policy Strategy, as amended effective on January 29,
2013, at www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf.
4
Real interest rates are not constrained by the zero bound, and the fact that expected average real short-term
interest rates are near zero reflects that the nominal rate is expected, on average, to run close to the expected
inflation rate, which is near 2 percent.
accommodative policy for some time: Most recently, the FOMC indicated that it expects to
maintain an exceptionally low level of the federal funds rate at least as long as the
unemployment rate is above 6.5 percent, projected inflation between one and two years
ahead is no more than a half percentage point above the Committee's 2 percent target, and
long-term inflation expectations remain stable.5
In discussing the role of monetary policy in determining the expected future path of real
short-term rates, I have cheated a little: What monetary policy actually controls is nominal
short-term rates. However, because inflation adjusts slowly, control of nominal short-term
rates usually translates into control of real short-term rates over the short and medium term.
In the longer term, real interest rates are determined primarily by nonmonetary factors, such
as the expected return to capital investments, which in turn is closely related to the
underlying strength of the economy. The fact that market yields currently incorporate an
expectation of very low short-term real interest rates over the next 10 years suggests that
market participants anticipate persistently slow growth and, consequently, low real returns to
investment. In other words, the low level of expected real short rates may reflect not only
investor expectations for a slow cyclical recovery but also some downgrading of longer-term
growth prospects.6
Chart 3, which displays yields on inflation-indexed, long-term government bonds for the
same five countries represented in chart 1, shows that expected real yields over the longer
term are low in other advanced industrial economies as well. Note again the strong similarity
in returns across these economies, suggesting once again the importance of common global
factors. While indexed yields spiked up around the end of 2008, reflecting market stresses at
the height of the crisis that undercut the demand for these bonds, these effects dissipated in
2009. Since that time, inflation-indexed yields have declined steadily and now stand below
zero in each country.7 Apparently, low longer-term real rate expectations are playing an
important role in accounting for low 10-year nominal rates in other industrial countries, as
well as in the United States.
The third and final component of the long-term interest rate is the term premium, defined as
the residual component not captured by expected real short-term rates or expected inflation.
As I noted, the largest portion of the downward move in long-term rates since 2010 appears
to be due to a fall in the term premium, so it deserves some special discussion.
In general, the term premium is the extra return investors expect to obtain from holding
longterm bonds as opposed to holding and rolling over a sequence of short-term securities over
the same period. In part, the term premium compensates bondholders for interest rate risk -
the risk of capital gains and losses that interest rate changes imply for the value of
longerterm bonds. Two changes in the nature of this interest rate risk have probably contributed to
a general downward movement of the term premium in recent years. First, the volatility of
Treasury yields has declined, in part because short-term rates are pressed up against the
zero lower bound and are expected to remain there for some time to come. Second, the
correlation of bond prices and stock prices has become increasingly negative over time,
implying that bonds have become more valuable as a hedge against risks from holding other
assets.8
Beyond interest rate risk, a number of other factors also affect the term premium in practice.
For example, during periods of financial turmoil, the prices of longer-term Treasury securities
are often driven up by so-called safe-haven demands of investors who place special value on
the safety and liquidity of Treasury securities. Indeed, even during more placid periods,
global demands for safe assets increase the value of Treasury securities. Many foreign
governments and central banks, particularly those with sustained current account surpluses,
hold substantial international reserves in the form of Treasuries. Foreign holdings of U.S.
Treasury securities currently amount to about $5-1/2 trillion, roughly half of the total amount
of marketable Treasury debt outstanding. The global economic and financial stresses of
recent years - triggered first by the financial crisis, and then by the problems in the euro area
- appear to have significantly elevated the safe-haven demand for Treasury securities at
times, pushing down Treasury yields and implying a lower, or even a negative, term
premium.9
Federal Reserve actions have also affected term premiums in recent years, most prominently
through a series of Large-Scale Asset Purchase (LSAP) programs. These programs consist
of open market purchases of agency debt, agency mortgage-backed securities, and
longerterm Treasury securities. To the extent that Treasury securities and agency-guaranteed
securities are not perfect substitutes for other assets, Federal Reserve purchases of these
assets should lower their term premiums, putting downward pressure on longer-term interest
rates and easing financial conditions more broadly. Although estimated effects vary, a
growing body of research supports the view that LSAPs are effective at bringing down term
premiums and thus reducing longer-term rates.10 Of course, the Federal Reserve has used
this unconventional approach to lowering longer-term rates because, with short-term rates
near zero, it can no longer use its conventional approach of cutting the target for the federal
funds rate.11 Accordingly, this portion of the decline in the term premium might ultimately be
attributed to the sluggish economic recovery, which prompted additional policy action from
the Federal Reserve.
Let's recap. Long-term interest rates are the sum of expected inflation, expected real
shortterm interest rates, and a term premium. Expected inflation has been low and stable,
reflecting central bank mandates and credibility as well as considerable resource slack in the
major industrial economies. Real interest rates are expected to remain low, reflecting the
weakness of the recovery in advanced economies (and possibly some downgrading of
longer-term growth prospects as well). This weakness, all else being equal, dictates that
monetary policy must remain accommodative if it is to support the recovery and reduce
disinflationary risks. Put another way, at the present time the major industrial economies
apparently cannot sustain significantly higher real rates of return; in that respect, central
banks - so long as they are meeting their price stability mandates - have little choice but to
take actions that keep nominal long-term rates relatively low, as suggested by the similarity
8
See, for example, Campbell, Sunderam, and Viceira (2009).
9
There are some additional more technical features of the Treasury market that push down the term premium.
For example, the Treasury term premium is likely also depressed by the global demand for Treasury securities
for use as collateral or margin in funding or derivatives markets.
10
See, for example, Gagnon, Raskin, Remache, and Sack (2011); Li and Wei (2012); Hamilton and Wu (2012);
D'Amico, English, López-Salido, and Nelson (2012); Rosa (2012); Krishnamurthy and Vissing-Jørgensen
(2011); and Hancock and Passmore (2012).
11
Term premiums, calculated using similar methods, have also declined fairly sharply recently in Canada,
Germany, and the United Kingdom; somewhat less so in Japan. This result is notable in that the central banks
of these economies, with the exception of the Bank of England, have not pursued large-scale purchases of
longer-term securities.
in the levels of the rates shown in chart 1. Finally, term premiums are low or negative,
reflecting a host of factors, including central bank actions in support of economic recovery.
Thus, while the current constellation of long-term rates across many advanced countries has
few precedents, it is not puzzling: It follows naturally from the economic circumstances of
these countries and the implications of these circumstances for the policies of their central
banks.
How are long-term rates likely to evolve?
So, how are long-term rates likely to evolve over coming years? It is worth pausing to note
that, not that long ago, central bankers would have carefully avoided this topic. However, it is
now a bedrock principle of central banking that transparency about the likely path of policy, in
general, and interest rates, in particular, can increase the effectiveness of policy. In the
present context, I would add that transparency may mitigate risks emanating from
unexpected rate movements. Thus, let me turn to prospects for long-term rates, starting with
the expected path of rates and then turning to deviations from the expected path that may
arise.
If, as the FOMC anticipates, the economic recovery continues at a moderate pace, with
unemployment slowly declining and inflation expectations remaining near 2 percent, then
long-term interest rates would be expected to rise gradually toward more normal levels over
the next several years. This rise would occur as the market's view of the expected date at
which the Federal Reserve will begin the removal of policy accommodation draws nearer and
then as accommodation is removed. Some normalization of the term premium might also
contribute to a rise in long-term rates.
To illustrate possible paths, Chart 4 displays four different forecasts of the evolution of the
10-year Treasury yield over coming years. The black line is the forecast reported in the
December 2012 Blue Chip Financial Forecasts survey. The green line gives the
Congressional Budget Office forecast published in February, and the blue line presents the
median from the Survey of Professional Forecasters, as reported in the first quarter of this
year. Finally, the purple line shows a forecast based on the term structure model used for the
decomposition of the 10-year yield in chart 2.12
While these forecasts embody a wide range
of underlying models and assumptions, the basic message is clear - long-term interest rates
are expected to rise gradually over the next few years, rising (at least according to these
forecasts) to around 3 percent at the end of 2014. The forecasts in chart 4 imply a total
increase of between 200 and 300 basis points in long-term yields between now and 2017.
Of course, the forecasts in chart 4 are just forecasts, and reality might well turn out to be
different. Chart 5 provides three complementary approaches to summarizing the uncertainty
surrounding forecasts of long-term rates. The dark gray bars in the chart are based on the
range of forecasts reported in the Blue Chip Financial Forecasts, the blue bars are based on
the historical uncertainty regarding long-term interest rates as reflected in the Board staff's
FRB/US model of the U.S. economy, and the orange bars give a market-based measure of
uncertainty derived from swaptions. These three different measures give a broadly similar
picture about the upside and downside risks to the forecasts of long-term rates. Rates
100 basis points higher than the expected paths in chart 4 by 2014 are certainly plausible
outcomes as judged by each of the three measures, and this uncertainty grows to as much
as 175 basis points by 2017. Note, though, that while the risk of an unexpected rise in
interest rates has drawn much attention, the level of long-term interest rates also could prove
to be lower than forecast. Indeed, by the measures shown in chart 5, the upside and
downside risks to the level of rates are roughly symmetric as of 2017.
We also have some historical experience with increases in rates during tightening cycles to
consider. For example, in 1994, 10-year Treasury yields rose about 220 basis points over the
course of a year, reflecting an unexpected quickening in the pace of economic growth and
signs of building inflation pressures. This increase in long-term rates appears to have
reflected a mix of a pronounced rise in the expected path of the policy interest rate and some
increase in the term premium.13 A rise of more than 200 basis points in a year is at the upper
end of what is implied by the mean paths and uncertainty measures shown in charts 4 and 5,
but these measures still admit a substantial probability of higher - and lower - paths.
Overall, then, we anticipate that long-term rates will rise as the recovery progresses and
expected short-term real rates and term premiums return to more normal levels. The precise
timing and pace of the increase will depend importantly on how economic conditions
develop, however, and is subject to considerable two-sided uncertainty.
Managing risks associated with the future course of long-term interest rates
As I noted when I began my remarks, one reason to focus on the timing and pace of a
possible increase in long-term rates is that these outcomes may have implications for
financial stability. Commentators have raised two broad concerns surrounding the outlook for
long-term rates. To oversimplify, the first risk is that rates will remain low, and the second is
that they will not. In particular, in an environment of persistently low returns, incentives may
grow for some investors to engage in an unsafe "reach for yield" either through excessive
use of leverage or through other forms of risk-taking. My Board colleague Jeremy Stein
recently discussed how this behavior may arise in some financial markets, including credit
markets.14 Alternatively, we face a risk that longer-term rates will rise sharply at some point,
imposing capital losses on holders of fixed-income instruments, including financial
institutions. Of course, the two risks may very well be mutually reinforcing: Taking on
duration risk is one way investors may reach for yield, and the losses resulting from a sharp
rise in longer-term rates will be greater if investors have done so.15
One might argue that the right response to these risks is to tighten monetary policy, raising
long-term interest rates with the aim of forestalling any undesirable buildup of risk. I hope my
discussion this evening has convinced you that, at least in economic circumstances of the
sort that prevail today, such an approach could be quite costly and might well be
counterproductive from the standpoint of promoting financial stability. Long-term interest
rates in the major industrial countries are low for good reason: Inflation is low and stable and,
given expectations of weak growth, expected real short rates are low. Premature rate
increases would carry a high risk of short-circuiting the recovery, possibly leading - ironically
enough - to an even longer period of low long-term rates. Only a strong economy can deliver
persistently high real returns to savers and investors, and the economies of the major
industrial countries are still in the recovery phase.
So how can financial stability concerns - which the Federal Reserve takes very seriously -
be addressed? Our strategy, undertaken in cooperation with other regulators and central
banks, has a number of elements.
First, we have greatly increased our macroprudential oversight, with a particular focus on
potential systemic vulnerabilities, including buildups of leverage and unstable funding
patterns as well as interest rate risk.16 Under the umbrella of our interdisciplinary Large
Institutions Supervision Coordinating Committee, we pay special attention to developments
at the largest, most complex financial firms, making use of information gathered in our
supervision of the institutions and drawn from financial market indicators of their health and
systemic vulnerability. We also monitor the shadow banking sector, especially its interaction
with regulated institutions; in this work, we look for factors that may leave the system
vulnerable to an adverse "fire sale" dynamic, in which declining asset values could force
leveraged investors to sell assets, depressing prices further. We exchange information
regularly with other regulatory agencies, both directly and under the auspices of the Financial
Stability Oversight Council. Throughout the Federal Reserve System, work in these areas is
conducted by experts in banking, financial markets, monetary policy, and other disciplines,
and at the Federal Reserve Board we have established our Office for Financial Stability
Policy and Research to help coordinate this work. Findings are presented regularly to the
Board and to the FOMC for use in its monetary policy deliberations.
Second, recognizing that our monitoring of the financial sector will always be imperfect, we
are using regulatory and supervisory tools to help ensure that financial institutions are
sufficiently resilient to weather losses and periods of market turmoil arising from any source.
Indeed, reflecting expectations embodied in the new Basel III and Dodd-Frank standards, the
largest and most complex financial firms have substantially increased both their capital and
their liquidity in recent years. Our current round of stress testing of the largest bank holding
companies, to be completed early this month, examines whether the largest banking firms
have sufficient capital to come through a seriously adverse economic downturn and still have
the capacity to perform their roles as providers of credit. In a related exercise, we are also
asking banks to stress-test the adequacy of their capital in the face of a hypothetical sharp
upward shift in the term structure of interest rates.
Third, our approach to communicating and implementing monetary policy provides the
Federal Reserve with new tools that could potentially be used to mitigate the risk of sharp
increases in interest rates. In 1994 - the period discussed earlier in which sharp increases in
interest rates strained financial markets - the FOMC's communication tools were very
limited; indeed, it had just begun issuing public statements following policy moves. By
contrast, in recent years, the Federal Reserve has provided a great deal of additional
information about its expectations for the path of the economy and the stance of monetary
policy. Most recently, as I mentioned, the FOMC announced unemployment and inflation
thresholds characterizing conditions that will guide the timing of the first increase in the target
for the federal funds rate. Further, the FOMC stated that a highly accommodative stance of
monetary policy is likely to remain appropriate for a considerable time after our current asset
purchase program ends. By providing greater clarity concerning the likely course of the
federal funds rate, FOMC communication should both make policy more effective and reduce
the risk that market misperceptions of the Committee's intentions would lead to unnecessary
interest rate volatility.
In addition, the Federal Reserve could, if necessary, use its balance sheet tools to mitigate
the risk of a sharp rise in rates. For example, the Committee has indicated its intention to sell
its agency securities gradually once conditions warrant. The Committee also noted, however,
that the pace of sales could be adjusted up or down in response to material changes in either
the economic outlook or financial conditions. In particular, adjustments to the pace or timing
of asset sales could be used, under some circumstances, to dampen excessively sharp
adjustments in longer-term interest rates.
Conclusion
Let me finish with some thoughts on balancing the risks we face in the current challenging
economic environment, at a time when our main policy tool, the federal funds rate, is near its
effective lower bound. On the one hand, the Fed's dual mandate has led us to provide strong
support for the recovery, both to promote maximum employment and to keep inflation from
falling below our price stability objective. One purpose of this support is to prompt a return to
the productive risk-taking that is essential to robust growth and to getting the unemployed
back to work. On the other hand, we must be mindful of the possibility that sustained periods
of low interest rates and highly accommodative policy could lead to excessive risk-taking in
some financial markets. The balance here is not an easy one to strike. While the recent crisis
is vivid testament to the costs of ill-judged risk-taking, we must also be aware of constraints
posed by the present state of the economy. In light of the moderate pace of the recovery and
the continued high level of economic slack, dialing back accommodation with the goal of
deterring excessive risk-taking in some areas poses its own risks to growth, price stability,
and, ultimately, financial stability. Indeed, as I noted, a premature removal of accommodation
could, by slowing the economy, perversely serve to extend the period of low long-term rates.
For these reasons, we are responding to financial stability concerns with the multipronged
approach I summarized a moment ago, which relies primarily on monitoring, supervision and
regulation, and communication. We will, however, be evaluating these issues carefully and
on an ongoing basis; we will be alert for any developments that pose risks to the
achievement of the Federal Reserve's mandated objectives of price stability and maximum
employment; and we will, of course, remain prepared to use all of our tools as needed to
address any such developments.
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