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Interest rates—the long and the short of it

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A weekly presentation of downloadable charts and short analyses designed to graphically illustrate important economic issues. Updated every Wednesday.

Snapshot for June 13, 2001.

Interest rates — the long and the short of it
Unless you are in the market to buy a house, you may not have paid much attention to the recent movements of long-term interest rates. But because so much of the U.S. economy relies on credit, a successful recovery will depend on low long-term interest rates for mortgages, car loans, or business loans. While the Fed has cut short-term interest rates, long-term interest rates are outside of its immediate sphere of influence. In fact, long-term interest rates on mortgages or business loans have remained stable or have even increased slightly since the beginning of the year. In other words, despite the Fed’s efforts, it is not becoming easier for people to refinance their homes or for businesses to invest.

The federal funds rate is the ultimate short-term rate since it is the rate that banks charge each other for overnight loans. It is, however, the only interest rate that the Federal Reserve Bank can effectively control. But the Fed changes do effect other short-term interest rates (e.g., one-year loans), which usually move very closely in line with the federal funds rate.

So despite the Fed lowering short-term interest rates by 2.5 percentage points since January 2001, the long-term rates for 30-year government bonds have remained stable or even increased slightly. The 30-year government bond rate is important because it is a benchmark for mortgage rates. Thus, mortgage rates follow the 30-year government bond rate very closely (see figure below). Subsequently, as 30-year rates remained stable, so did mortgage rates.

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Because short-term (one-year) rates have fallen, but long-term rates have remained stable, the ratio of long-term rates to short-term rates – a simple tool to track what is happening in financial markets – has risen. As the figure shows, the ratio of long-term to short-term has increased dramatically over the past few months. The rates for 30-year bonds are 5.8%, and the rates for 1-year t-bills equal 3.5%, a differential of 2.3 percentage points between the two rates, or 60%. This is the largest differential since April 1994.

Under normal circumstances, long-term interest rates usually match the direction of short-term rates, although rising and falling at a slower pace. It is quite exceptional to have a situation like the current one in which short-term rates drop and long-term rates rise.

There may be several reasons why these rates are currently diverging. The large tax cuts recently enacted may have helped to keep interest from falling further. Larger tax cuts mean that future surpluses will be smaller or that the government may even operate out of a deficit. Therefore, the supply of long-term government debt will not shrink as fast as anticipated, which translates into higher long-term yields. Similarly, the financial markets may interpret the large tax cuts as a potential for increasing inflation in the future. However, lenders will ask for higher interest rates if they think that inflation will increase during the course of a loan. So, while households may receive some money from the tax cuts in the distant future, they pay high interest rates on mortgages or other consumer debt right now – at a time when the employment and wage outlooks are weakening.

This week’s Snapshot by EPI economist Christian E. Weller.

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