Dr. Mike Walden
North Carolina Cooperative Extension
The year was 1978. A young, newly hired economics professor was making one of his first public presentations to a group in Washington, N.C. The professor quickly learned locals referred to their town as “Little Washington,” to distinguish it from the nation’s capital. He was also told Little Washington was founded years before Washington, D.C., and was the first city to be named after George Washington.
Equipped with this important information, the professor talked to the assembled group about the condition and outlook of the current economy, both in the nation and in North Carolina. But when it came time for questions, it was clear most people were upset about one thing — interest rates. The most common questions asked were “Why are mortgage rates 10 percent?” and “When will they get lower so I can afford to buy a home?”
That newbie professor with a full head of hair (wish that was still the case) was me! Now, almost 40 years later, I’m reminded how economics can change. Today the average 30-year fixed conventional mortgage rate is under 4 percent. In some countries interest rates are actually negative. Yet in 1978 the worst was yet to come. The 30-year fixed mortgage didn’t peak until 1981 at — hold on to your hats — 18.5 percent.
The turnaround in interest rates is one of the biggest economic stories of the last 70 years. Interest rates began a steady climb after World War II, rising threefold to peak in the early 1980s. But since then they have tumbled almost as fast as they rose. This leaves us with two big questions: Why have interest rates dropped so much, and will they remain low?
There are four major factors behind the multi-decadal plunge in interest rates: globalization, low inflation, Federal Reserve policy and slow economic growth.
Globalization is shorthand for the world’s economic linkages strengthening, and three big events have really spurred it. One was the collapse of the former Soviet Union, which allowed countries — mainly in Eastern Europe — to increase economic linkages with the rest of the world.
Second was the movement of China from a tightly, centrally controlled economy with little international interaction to an economy with private incentives and profits and significant trading with the world.
Third was the acceleration in the last two decades of international trade agreements that lowered trade barriers between countries and resulted in increased country-to-country buying and selling.
The upswing of these three changes — in the analysis of one economist — is that 3 billion people joined the world economy through increased production, selling, buying and trading. The world, including the United States, has experienced a large increase in available products and services, which lowers both costs and prices. One of these lower prices is the interest rate, which can simply be viewed as the price of moving resources (money) from the future to today.
Globalization has also interacted with inflation to make average prices rise at a slower rate. With more people worldwide working, making and selling things, the U.S. annual inflation rate has dropped from 13.5 percent in 1980 to 2 percent today. A key factor is determining an interest rate is the expected future inflation rate. When inflation is higher, the purchasing power of future dollars is lower. Lenders, therefore, must charge higher interest rates to counteract the lower valued future dollar. So when inflation falls, so, too, do interest rates.
Economists have long argued that massive money-printing by the Federal Reserve Bank, or the Fed, in the mid- to late 1970s had much to do with the run-up in both inflation and interest rates during that period. In the last 40 years the Fed seems to have learned its lesson and has closely tracked the inflation rate and carefully increased the supply of money and credit. The Fed did rapidly increase money creation during the financial crisis of the Great Recession, but the Fed held most of that money in their vaults rather than putting it out on the street.
Last, some analysts say one of the benefits of the slowly expanding economy in the last decade has been low interest rates. With the economy relatively sluggish, borrowing has not been as strong, and this has helped keep the price of money – the interest rate – low.
Of course, not everyone is happy with low interest rates, particularly savers who want to put their money in safe investments, like CDs and Treasury securities. In some cases the interest rates paid on these investments have not even kept pace with inflation.
My best bet about future interest rates is they will remain low. However, if globalization were to be pulled back, if the Fed flooded the economy with money, or if economic growth suddenly exploded, then interest rates would jump. I don’t see any of those events in the cards, but you decide!
— 30 —
Dr. Mike Walden is a William Neal Reynolds Distinguished Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of North Carolina State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The College of Agriculture and Life Sciences communications unit provides his You Decide column every two weeks.
Previous columns are available at http://www.cals.ncsu.edu/agcomm/news-center/tag/you-decide
Related audio files are at http://www.cals.ncsu.edu/agcomm/news-center/category/economic-perspective