IMF sees risks in abnormally low long-term rates Wed Apr 13, 2005 09:18 AM ET
WASHINGTON, April 13 (Reuters) - Long-term U.S. interest rates are abnormally low for this stage of the economic cycle and any sudden removal of extraordinary factors depressing them could hurt the economy, the IMF said on Wednesday.
The International Monetary Fund set out several reasons why long-term rates remain so low in the face of robust growth and rising official rates -- developments described by Federal Reserve chief Alan Greenspan in February as a "conundrum."
In its twice-yearly World Economic Outlook, the IMF said the decline in 10-year interest rates since the Fed started tightening official rates last June could not be explained by economic fundamentals alone.
"While the low level of nominal rates partly reflects subdued inflation, a comparison of nominal and inflation-adjusted yields indicates that real returns are also abnormally depressed," the IMF said.
With low long rates critical to U.S. housing markets, household consumption and demand for imports, a sudden correction could jolt both the U.S. and world economies.
Ten-year U.S. interest rates, set by the U.S. Treasury bond market, rose sharply after Greenspan spoke on the issue in February. But at 4.35 percent at present, rates are little changed from one year ago and almost half a point below levels set just prior to the first of seven Fed rate rises last June.
The IMF said low inflation expectations, due to sizeable economic slack and the inflation-fighting credibility of the Fed, has helped lower the bond market's trajectory for further official interest rate rises.
But this only partly explains such subdued long rates.
The IMF said the slow pace of anticipated rate rises helped keep long rates low and an expected rise in Fed rates to 4 percent by the end of the year from 2.75 percent now would equate to a half-point rise in 10-year rates.
"However, this would still leave rates well below historical averages," it said.
The Fund said structural and cyclical factors play a part.
Aversion to equities since the bubble burst of 2000 may have increased demand for bonds while greater regulation and oversight of pension funds may be forcing managers to better match long-term liabilities with safer long-term securities.
Other factors included a reluctance among companies to boost investment despite rising profits -- leading to a dearth of new debt issuance from non-government borrowers.
"The overall corporate financing gap of nonfinancial and financial businesses has improved by an unprecedented 5 percent of GDP (gross domestic product) since 2001," the IMF said.
This, combined with huge demand for U.S. Treasury and agency bonds from foreign central banks as Asia rapidly accumulates U.S. dollar reserves, has put downward pressure on long rates.
The Fund said the sudden removal of any of these factors could result is a sharp rise in long-term rates.
"The most benign scenario would be if long-term interest rates were driven upward by a reduction in net loanable funds owing to increased investment by domestic firms," it said.
While housing and consumption would be hit, it would at least be partly offset by the rise in business investment. The spillover to the rest of the world via rising costs of Treasury bond-linked borrowing would be negative, however.
A jump in rates unaccompanied by rising business investment -- triggered by rising inflation or falling corporate profits for example -- would be more severe for both the U.S. and global economies, the IMF said. U.S. import demand would suffer along with domestic housing and consumption.
An ebbing of foreign demand for U.S. securities, on the other hand, could hit the U.S. economy without necessarily affecting the rest of the world as long as those funds were reallocated to other countries.
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