The Federal Reserve will most likely raise interest rates this week for the first time in nearly a decade. To understand what it means — and doesn’t mean — consider a previous year in which interest rates were on the rise.
In 1920, borrowing costs soared to their highest levels since the end of the Civil War. Some people were terrified of what it was doing to the economy. Higher rates “would practically legalize usury,” a real estate trade group warned. A Democratic senator complained that “manufacturers, merchants and business men are entitled to stability.” The Federal Reserve was “confronted with conditions more or less abnormal,” acknowledged a governor of the central bank, William P.G. Harding.
The interest rate that caused this angst? A mere 5.4 percent on the 10-year United States Treasury bond — lower than the rates during the entirety of the 1980s and most of the 1990s.
What does this have to do with the Fed’s likely move this week? For years, financial commentators have been predicting an imminent rise in rates. After all, goes the theory, the Fed has been engaged in extraordinary interventions to artificially depress the cost of borrowing money. Surely those rates will snap back to their pre-2008 levels, if not rise higher. If that happens, get ready for double-digit mortgage rates and substantially higher cost to maintain the government debt.
But if you look at the longer arc of history, a much different possibility emerges. Investors have often talked about the global economy since the crisis as reflecting a “new normal” of slow growth and low inflation. But, just maybe, we’ve really returned to the Old Normal.
Very low rates have often persisted for decades upon decades, pretty much whenever inflation is quiescent, as it is now. The interest rate on a 10-year Treasury bond was below 4 percent every year from 1876 to 1919, then again from 1924 to 1958. The record is even clearer in Britain, where long-term rates were under 4 percent for nearly a century straight, from 1820 until the onset of World War I.
The real aberration looks like the 7.3 percent average experienced in the United States from 1970 to 2007.
“We’re returning to normal, and it’s just taken time for people to realize that,” said Byron Taylor, chief economist of Global Financial Data, which scours old records to calculate historical financial data, including that cited here. “I think interest rates are going to stay low for several decades.”
If so, it would mean that many predictions through the last several years of ultralow interest rates have misread the situation. “Once the economy gets going, then interest rates are going to take a big leap,” said George Soros, the billionaire hedge fund manager, in a 2013 CNBC interview.
“We can expect rapidly rising prices and much, much higher interest rates over the next four or five years,” wrote the economist Arthur B. Laffer in The Wall Street Journal in 2009. In 2014, all 67 economists surveyed by Bloomberg predicted higher rates six months hence; they instead fell sharply.
Of course, rates could go up. But what that analysis may have missed is that interest rates historically are most closely tied to inflation. How much investors demand as compensation for loaning their money is shaped in no small part by how much they think that money will be worth when they get it back. And the pressures that normally generate inflation seem to have disappeared in recent years.
The Fed and its counterparts overseas at the European Central Bank and Bank of Japan have spent the last few years applying every policy they can think of to get inflation to rise up to their 2 percent target, with limited success. In a world awash in supply of workers, oil and more, financial markets show little sign that investors think that will change anytime soon. Current Treasury bond prices predict annual inflation in the United States of only 1.7 percent a year over the next three decades.