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Bernanke: Thoughts on Long-Term Interest Rates

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Mark Thoma sends us to Neil Irwin on Bernanke and Yellen versus Stein:

Jeremy Stein… argued… that there are already signs of overheating in the markets for certain kinds of securities, including junk bonds and real estate investment trusts…. If the last 15 years have taught us anything, it is that financial bubbles can wreak huge damage to the economy, so it’s worth it to try to nip them in the bud. The two most powerful Fed officials… offered… riposte[s]…. 'Long-term interest rates in the major industrial countries are low for good reason', Chairman Ben Bernanke said Friday evening…. Vice-chair Janet Yellen chimed in Monday morning… "there are some signs that investors are reaching for yield, but I do not now see pervasive evidence of trends such as rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would clearly threaten financial stability." So the Bernanke-Yellen response to the Stein-George argument boils down to a polite version of this: Are you crazy? Unemployment is really high! Inflation does not appear to be much of a threat! Why should we cripple the prospects of economic recovery just because investors may be paying too much for certain types of corporate bonds and end up losing money?

Ben S. Bernanke: Thoughts on Long-Term Interest Rates

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…. [But a] more complete explanation of the current low level of rates must take account of the broader economic environment…. [I]t is useful to decompose longer-term yields into three components… expected inflation… the expected path of short-term real… rates; and… the term premium….

The expected inflation component has drifted gradually downward… increasing credibility of the Federal Reserve's commitment to price stability…. 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… may reflect not only investor expectations for a slow cyclical recovery but also some downgrading of longer-term growth prospects…. The largest portion of the downward move in long-term rates since 2010 appears to be due to a fall in the term premium… 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.

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So, how are long-term rates likely to evolve over coming years?… If, as the FOMC anticipates, the economic recovery continues… [with] inflation expectations remaining near 2 percent, then long-term interest rates would be expected to rise gradually toward more normal levels… 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….

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…. [I]ncentives may grow for some investors to engage in an unsafe "reach for yield"…. Alternatively, we face a risk that longer-term rates will rise sharply at some point, imposing capital losses on holders of fixed-income instruments…. 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.

One might argue that the right response to these risks is to tighten monetary policy…. 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….

On the one hand, the Fed's dual mandate has led us to provide strong support for the recovery…. 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…. The balance here is not an easy one to strike…. [D]ialing 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.