## Commentary – Interest Rates

Long-term and short-term nominal interest rates have shown a similar pattern over the last 60 years for most countries for which we have data. From levels of around 4 or 5% in the 1950s rates rose to a peak of the mid- or high-teens in the 1970s and 80s. Since then they have fallen steadily and are now at historically very low levels. The rise in interest rates in the 70s and 80s was due to the rise in inflation in that period: to be encouraged to hold assets whose real value was decreasing borrowers had to be offered a high nominal interest rate to safeguard a positive real return. The subsequent decline is similarly most likely due to the decline in inflation.

Short term interest rates have tended to be more volatile than long-term interest rates.

In the 2010s short-term nominal interest rates in the major industrialised countries have been some of the lowest ever recorded; many are close to zero.

Average long-term interest rates in the 2010s are also historically low. In almost all countries they are noticeably lower than their equivalents in the 2000s. The countries in the Eurozone who were forced to seek financial assistance – Spain, Portugal, Greece and Ireland – are exceptions. This almost certainly is due to concerns about the possibility that these countries’ governments might default – i.e. become unable to pay the interest on their loans or repay the principal: given such concerns bond holders require a higher return to be persuaded to take on the perceived risk. By 2015 these concerns seem largely to have disappeared in the case of Ireland and Spain whose long-term interest rates were then below that of the UK. But they remained for Greece even before the election of the Syriza-led government.

Low nominal interest rates do not necessarily mean low real interest rates, as the UK experience in the 1970s illustrates. Because of the high inflation in that period nominal interest rates in the high teens were not always sufficient to generate positive real interest rates – sometimes they were as low as -10%. In recent years though, the decline in nominal interest rates in the UK has been matched by a decline in real interest rates so that real rates have been only a little above zero and sometimes mildly negative. [In the graph below the UK long term interest rate is the per annum nominal interest rate for the quarter minus the rate of growth of the GDP deflator over subsequent year.]

Interest rates on the debt of the same institution are typically higher the longer the time to maturity. So, for example, the interest rate on UK government 20-year bonds will generally be higher than the interest rate on UK government 3-month Treasury Bills. The ‘yield curve’ for (or term structure of) UK government securities on 30th September 2014 is typical.

One explanation for this is that there is more risk involved in holding an asset with a long life – the future is always uncertain – and the promise of a higher return is necessary to make the asset attractive.

Another influence on the yield curve is the expected future value of the short term interest rate. Say the interest rates on a 1-year bond and a 2-year bond are both 3%. If the shorter-term interest rate is expected to rise to 4% in a year’s time then investors are expecting to earn a return of roughly 3.5% over two years by holding a 1-year bond for a year and then buying another 1-year bond in a year’s time. The 2-year bond return would look unattractive: its price would fall until it too offered a return over two years of roughly 3.5%. [The price of a bond and its return are mathematically inversely related. For example, a 1-year bond is a promise to pay a fixed sum of money to its owner in a year’s time, say £105. If the price of the bond is £100 then its return is 5%; if its price is £95 its return is over 10%.]

So expectations of a rise in short-term interest rates imply an upward sloping yield curve. And this may explain why at times there is an inverted yield curve – short-term interest rates above long-term yields: investors are expecting short-term interest rates to fall. The curve for 31st March 2005 provides an example.