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What Japan and Australia can tell us about low US interest rates

Prime Minister Shinzo Abe has been struggling to get Japan out of its low-inflation, low-interest-rate, low-growth rut.
Prime Minister Shinzo Abe has been struggling to get Japan out of its low-inflation, low-interest-rate, low-growth rut.
(Andrew Gombert/Pool/Getty Images)

When I bought a house back in June, my lender encouraged me to lock in our interest rate quickly because mortgage rates couldn't stay so low — they were around 3.85 percent at the time — for much longer. Six months later, the average mortgage rate in the Washington DC area is still 3.85 percent.

People have been predicting imminent rate hikes for years: Rates were said to be about to go up in 2013, in 2011, and in 2009. In 2010, a New York Times columnist predicted that "interest rates have nowhere to go but up." Mortgage rates are now lower than they were at the time any of those articles was written.

It's not too surprising that people were fooled. If you compare today's rates with those that prevailed in the 1970s, 1980s, or 1990s, they look freakishly low. But the New York Times's Neil Irwin points out that if you take a longer-term perspective, today's low rates don't look so anomalous:

(Robert Shiller, via Phil DeMuth)

The interest rate on 10-year government bonds is currently 2.2 percent, about the same as it was in the 1930s, 1940s, and 1950s. If you take this longer perspective, the high interest rates of the past few decades look like the anomaly, and today's 2.2 percent rate looks like a return to normal.

Irwin argues that this is mostly about inflation. When inflation is high, people demand higher interest rates to compensate for the declining value of the principal. So when inflation skyrocketed in the '70s, interest rates skyrocketed too — and fears that inflation would return kept rates high throughout the '80s and '90s, even as inflation fell. Only recently have interest rates returned to a more historically normal level.

Irwin is clearly right that low inflation is an important reason for interest rates to be low. But another big factor is the changing demographics of the American economy.

Why slow population growth means low interest rates

Many factors contribute to interest rates, but on the most fundamental level they reflect a market judgment about how much opportunity there is to generate future wealth from present-day investments.

When the economy is growing quickly, there are lots of ways to turn dollars into productive assets — factories, roads, houses — which can then generate wealth in the future. So the competition for investment dollars is strong, and interest rates rise.

On the other hand, if tomorrow's economy won't be much bigger than today's, then we'll be able to serve most of our needs with the factories, roads, and houses we already have. So few people will want to borrow and invest, pushing interest rates down.

We can't say exactly how fast the economy is going to grow over the next few decades, but one thing we can be pretty sure about is that the US population is going to be growing more slowly. In the 1960s, investors could look forward to a future with many more people — and many more potential consumers — than there are now. Today, that's not as true. The US population is still growing, but thanks largely to falling birthrates, it's growing at about half the rate it did in the mid-20th century.

And the population growth rate has fallen even more in other rich countries. Japan has 127 million people, barely more than the 124 million it had in 1990, and its population has actually been falling the past few years. Italy has 61 million people, just 7 percent more than the 57 million who lived there in 1981.

If your country's population has stopped growing, there's little point in building a bunch of new houses, stores, or office buildings. There's less need for new roads, schools, or other infrastructure. Of course, you'll still need to spend some money repairing or replacing facilities that become obsolete or worn out, but the total amount of investment spending is going to be a lot lower.

It's not a coincidence that Japan — the rich country with the biggest population slowdown — has also been stuck in a low-inflation, low-interest rate, low-growth rut for longer than other rich countries. It's hard for a country with a shrinking workforce to have a growing economy, and without economic growth there's little demand for borrowing.

On the other hand, Australia is one of the world's fastest-growing rich countries. Over the past 20 years, Australia's population has grown 33 percent — about the same as the US growth rate between 1950 and 1970. And it's probably not a coincidence that Australia (blue line) has higher interest rates than the United States (green), while Japan's (red) interest rates are lower.

FRED

The Fed has less control over interest rates than you think

The United States still has a growing population and a growing economy. But both are growing more slowly than in decades past, and as a result we're experiencing a milder version of Japan's doldrums. One symptom of that is lower interest rates. And since America's low population growth isn't likely to change any time soon, its low interest rates may not either.

A lot of people have pointed to the Federal Reserve as the cause of today's low interest rates, but the Fed has less power than people think. It's true that the Fed controls short-term interest rates, and is expected to raise those rates this week for the first time in nine years.

But long-term interest rates are controlled by the market, not directly by the Fed. And in practice, the Fed's ability to raise even short-term rates are constrained by market conditions. If the Fed raises rates too high or too quickly, it will trigger a recession, forcing the Fed to cut rates once again. So in practice, broad economic trends, not the whims of Fed Chair Janet Yellen, are the main reason interest rates are so low.