Despite frequent, dire warnings about the unsustainability of government budget deficits in the United States, Europe and Japan, investors are lining up to lend to some governments at very low interest rates. Interest rates on 10-year U.S. treasury notes are about 2%, close to record lows. The same is true in Germany and interest rates on Japan's 10-year government bonds are below 1%.
This outcome is all the more surprising when, added to fear over oversupply of government debt, are warnings that the support given to debt markets by central banks amounts to the printing of money, an undertaking that can lead to sharply higher inflation. The expectation of sharply higher inflation usually drives up interest rates, especially on longer-term debt, since investors expect to be paid back in currency whose purchasing power has been eroded by higher prices.
There are three factors behind the failure of interest rates to rise. Consider U.S. government 10-year bonds which serve as a benchmark for high grade bonds issued by borrowers like Germany and Japan. First among the reasons for low interest rates is the fact that actual inflation has been coming down. U.S. headline inflation is almost a full percentage point below where it was about four months ago and it is expected to fall further toward midyear. Inflation in Germany is coming down and Japan is actually experiencing deflation.
"The extension of the 2011 tax breaks into 2012 by the Congress will probably help to keep growth close to the 2% level."
The second reason for lower interest rates is the outlook for moderating growth. Europe is heading into recession for 2012 while Japan's growth rate is probably going to be negative as well. Meanwhile U.S. growth is expected to be about 2% after a brief rise to 3% at the end of 2011.
Moderate to negative growth expectations in the world's largest advanced economies -- while growth and inflation are moderating in China, the world's second-largest economy -- are undercutting the inflation fears that many have claimed were justified based on the central banks printing money to purchase bonds. Lower-than-expected growth leaves investors who are seeking the safety of, say, a 2% return with moderating inflation risks more favorably disposed to bond purchases.
The third factor keeping interest rates low is a persistence of risk aversion among many investors. The negative shocks of 2011 including the Arab spring, Japan's tsunami-nuclear disaster, the ugly midyear battle over the U.S. debt ceiling and the 4th quarter intensification of Europe's sovereign debt crisis, all contributed to elevated risk aversion. As inflation risks abate, the safe haven represented by high-grade government bonds looks even safer.
For households and firms wishing to hold a high level of very liquid safe assets another alternative is U.S. treasury bills that are highly liquid and continue to be favored assets. The near zero and sometimes-negative interest rates on three-month treasury bills underscore the intensification and persistence of risk aversion evident in 2012.
Looking ahead, 2012 may see fewer risk events shocking investors than occurred in 2011. The recent rise in stock prices suggests that some investors are hoping for such an outcome. But the persistence of low interest rates on high-grade government bonds suggests residual caution among many investors who apparently are more worried about weaker growth and volatile credit risks among low-rated government bonds than they are about higher inflation.
In retrospect, the cautionary moves undertaken at the end of 2010 by the Federal Reserve and the Congress, may not have been such a bad idea as they helped cushion the U.S. economy from the shocks of 2011. Inflation has not run away and indeed has moderated while some growth has appeared at the end of 2011 that will help create a modest growth momentum going into 2012. The extension of the 2011 tax breaks into 2012 by the Congress will probably help to keep growth close to the 2% level.
But there are problems. Under current law, by the end of 2012 the total fiscal drag imposed on the U.S. economy will be close to 5 percentage points of GDP because of expiring tax cuts and stimulus measures. The new Congress and the new president elected in November will surely have their hands full moving forward.
Meanwhile, the shaky outlook for fiscal policy and the uncertainty about how it will be resolved perhaps helps to account for continued low inflation expectations and a persistence of risk aversion that, for now at least, is helping to keep interest rates low.
John Makin is a resident scholar at AEI