How Long Will Low Interest Rates Last?

Are we really borrowing for free, and should we be taking advantage of it?

Over the last few years, we’ve seen interest rates continue to fall to shocking lows. Less than a month ago, investors accepted the lowest yields ever for 10-year US Treasury bonds at a yield of 1.459 per cent, and current 10-year yields, adjusted for inflation, sit at -0.65 percent. In fact, US Treasury yields are now negative for bonds with maturities up to 20 years after accounting for inflation.

This has sparked some to argue that we should be taking advantage of these low rates to undertake new investments or tax cuts, often with sizable costs. Matt Yglesias argues in a Slate article today that "right now the government can borrow money basically for free, so there’s little reason to pay for anything" when discussing Mitt Romney's proposed tax cuts and the Tax Policy Center study about them. Yglesias has previously written in support of taking advantage of low yields for short-term stimulus. While he acknowledges that borrowing money on a large scale can tend to raise interest rates and "crowd out" private investment, he believes that since rates are so low right now, it’s imprudent not to take advantage of the opportunity.

But how long can these low rates last? That’s the question economist Ken Rogoff poses in an article also published today in which he argues that while interest rates may be attractively low and stable now, it’s not going to last forever. Rogoff cites three main causes which have produced what he describes as a "perfect storm" for today’s low yields; causes that are only temporary:

• Savers are abundant in many regions with aging populations such as Japan and Germany. Because of demographics, there are many near-retirees who have to save up for retirement, thus providing plenty of funds for the government to draw on. However, as those near-retirees increasingly become retirees over the next several years, they will be drawing on those savings and the "savings glut" will subside.
• Major central banks have brought down short-term policy interest rates near zero, but when economies recover -- which is looking better for the U.S. than some European countries -- they will have to bring interest rates up.
• Investors are becoming increasingly wary of a global meltdown with Europe on the brink of crisis. Good or bad, it will be resolved eventually, which will lessen the flight to safety that is driving the exceptionally low yields on U.S. debt instruments.

We'd also add on the third point that, assuming the U.S. economy gets back to normal, investors will move their money out of bonds and into riskier assets.

What is the problem if rates go up? Debt created right now can be financed at the current very low rates, but it will have to be rolled over eventually at higher rates. One third of public debt will be rolled over in two years and half in four years, so it would be unlikely that the Treasury Department would be able to lock in low rates for an extended period, despite their current attempts to utilize more long-term Treasuries. For the reasons Ken Rogoff discusses, along with the economic recovery, we can be very sure that interest rates will rise. Once those bonds are rolled over at higher rates, new borrowing accrued today will cost a lot more down the road if it's not paid for -- just adding to our fiscal challenges that predominantly lie down the road a few years. In other words, at that point, it won't be free money.

Update: This blog now shows recent Treasury data on how much of public debt is rolled over within one and two years.