The message that the Federal Reserve’s John Williams delivered last week in the Twin Cities is that we have to get used to the idea that low interest rates are really just normal now.
Much of the talk Williams gave at the Economic Club of Minnesota was built around an economics concept called the neutral or natural rate of interest, although he used a different term. He would probably object to it being simplified like this, but the natural rate is like an interest rate that isn’t so hot it stokes inflation or so cold that it freezes growth and investment.
Williams, the president of the San Francisco Fed, has settled on about 0.5 percent for the real natural rate of interest, meaning the part of the interest rate apart from inflation. About 20 years ago it was 2 full percentage points higher.
So one question, and without checking the rate of interest you are getting paid on a savings account: Does it feel like interest rates are starting to get back to normal?
Maybe the answer depends on how long you’ve been around. In summer 1983, when First Bank St. Paul brought me aboard as a 22-year-old recent grad from Macalester College and tried to teach me the bond business, the 10-year Treasury note yielded more than 11 percent.
The rate on the 10-year last week? About 3.1 percent.
It always pays to be at least a little skeptical of talk of a new normal, but even if you left Williams’ talk shaking your head, he was still well worth taking in. He will soon head the New York Federal Reserve Bank, a job maybe second in influence only to the Fed chairman in Washington on all things related to monetary policy.
Given his visibility, saying generally reassuring things in Minnesota about the economy and the course of monetary policy probably made a lot of sense.
He’s also far from the only person to be talking about how the so-called natural rate is far lower than it used to be. (By the way, he’s talking about a rate in the capital market, not the very short-term rate everyone talks about when the Fed is trying to raise interest rates.)
As he put it, everybody from the top managers of big banks down to small business owners and home buyers needs to plan for that to persist for a good long while.
As for why this interest rate can remain low, he started with simple demographics. The retirements of the baby boomers and a low birthrate mean the labor force in the country is going to grow very slowly. More people working and buying things would be better for economic growth than more people sitting at home.
Productivity growth has also been sluggish lately, meaning the basic measure of value of what a worker produces.
He also noted another main factor: that investors have recently gravitated toward the safest assets they could find, bidding them up in price.
This is key to how interest rates shape the expectations of return on investment for business managers, investors and even homeowners. Interest rates matter a lot when trying to figure out what to pay for an asset like an apartment building down the block.
It’s a counterintuitive calculation, too. If investors are willing to accept lower returns, that means they are willing to pay more for an asset.
Why would they pay more just because interest rates are low? One reason is that the cost to borrow money to fund the acquisition might be really cheap, but the better reason is that investment opportunities throughout the market don’t pay much better. Without accepting a lot of risk, what’s a better idea for the money?
Not that long ago, investors would not touch an apartment building that paid less than a 7 percent rate of return. That’s arrived at by dividing all the rent money left over after expenses by what an investor paid for the building.
Today it’s possible for an apartment building to trade hands at maybe a 4.5 percent expected rate of return, even lower for newer buildings in good locations.
“In a world of slower growth and lower real interest rates, then some of the asset prices we are seeing today, like commercial real estate, residential real estate or [stocks], are justified by that,” Williams said, responding to a question after his talk.
One of the most pointed questions Williams took from the floor last week came from Bryce Doty, a veteran manager of fixed-income investments with Sit Investment Associates in Minneapolis.
When I caught up with Doty later, he was more than a little skeptical of a new normal. And it was a treat to hear a Fed president’s ideas through the filter of somebody who invests in bonds for a living, even though they may not have been talking about precisely the same things, maybe Braeburn apples vs. Golden Delicious.
One conclusion from talking to Doty was that it might not be long before buying an apartment building at just a 4 percent expected rate of return doesn’t seem like such a swell idea.
“I was talking to a consultant, and he asked what the downside is, what do I think could go wrong,” Doty said. “I said we’re experiencing it. This is the downside.”
In January, the interest rate, or yield, on the 10-year Treasury note was less than 2.5 percent. Now it’s more than 3.1 percent, the highest it’s been in roughly seven years. And when interest rates increase, the value of all sorts of bonds, including Treasuries, goes downhill.
“The new normal thing? You can stick with that,” Doty said. “[But] at some point write an article that says ‘Here’s the reality we are in, here’s the reality we used to be in.’ Rates were on this long-term downward trend. And now we’ve begun a new cycle.”