For the Fed's Interest Rates, Low Is the New Status Quo

The Wall Street Journal

It is time to get used to near-zero savings-account interest rates and 10-year bond yields that don't get much higher than 3%.

Yes, the Federal Reserve is preparing to raise rates as soon as next spring. But even that won't produce the interest-rate "normalization" that many assume to be on the way.

That overdue reversion to the mean of recent decades—pined for by retirees and other risk-averse savers, feared by holders of higher-yielding bonds—isn't coming.

Blame it on the persistent sources of fragility in the global economy: banks that remain reluctant to lend to Main Street, a looming debt crisis in China and the alarming prospect that deflation will come to Europe's shores and return to Japan's.

Scott Mather, deputy chief investment officer at bond fund manager Pacific Investment Management Corp., which has $2 trillion in assets under management, says the eventual resting point for rates will be much lower and "the Fed will take a lot longer to get there than in previous cycles. And a chief reason for that is all the overhangs that we have."

The initial move, certain to be a mere quarter of a percentage point, will have only the slightest impact on money-market rates, since banks still will be borrowing short-term money at not much more than 0%. Yet because of underlying economic weakness, even this modest credit tightening could temper growth and reflexively give the Fed pause. It isn't hard to imagine that first increase being followed by a six-month or even yearlong hiatus.

That is a far cry from past periods of policy normalization, when signs of economic recovery would send the Fed off on a multiyear campaign of interest-rate increases.

But it is very difficult for economists to abandon their old normalization models. Even though there is intellectual appreciation that liftoff will be slower than in the past and implicit acknowledgment of former Treasury Secretary Lawrence Summers's "secular stagnation" thesis, routine policy normalization is baked into base-case projections.

The Federal Open Market Committee's own "blue dot" projections for the federal-funds rate capture this. In June, its 16 members' median forecast stood at 1.13% for the end of 2015, then sloped up to 2.5% at end-2016 and to 3.75% in the "long run" beyond that.

While that long-run forecast marked a modest reduction from March's 4% median, it is far higher than the 2% or less that believers in the secular-stagnation thesis now cite.

Also, banks, those vital drivers of business expansion, are much less willing to lend than they were before the 2008 crisis. Describing bank staff who are "very clearly focused on the penalties for getting things wrong and building risk aversion into the way they think," HSBC Chairman Douglas Flint blamed the slow credit recovery on the heavy burden of new regulations.

And RBS Securities fixed-income strategist Bill O'Donnell argued that regulation's chastening effect has caused an overdependence on the Fed for financial liquidity. When that dries up, he said, "nobody really knows how the system will hold up under duress."

We shouldn't blame all this on overzealous regulators. Banks' prior excesses and the damage they wrought necessitated a regulatory response. The problem is that it exacerbated a difficult economic environment because fiscal policy makers had failed to devise more effective stimulus measures such as infrastructure-investment programs.

Politicians don't seem capable of righting that wrong, which means the Fed remains the only game in town. In other words, superlow interest rates will be with us for a long time.

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