5 myths about in­ter­est rates.

The Washington Post Sunday - - OUTLOOK - BY SU­SAN LUND AND RICHARD DOBBS Su­san Lund is the re­search di­rec­tor at the McKin­sey Global In­sti­tute. Richard Dobbs is the in­sti­tute’s di­rec­tor and a se­nior part­ner in McKin­sey & Com­pany’s Seoul of­fice. mgi@mckin­sey.com

In­ter­est rates, which have been so low for so long that con­sumers and busi­nesses have come to con­sider it an en­ti­tle­ment, are start­ing to creep up­ward, prompt­ing new con­cerns and de­bates. Will higher rates un­der­cut the eco­nomic re­cov­ery? Should the Fed­eral Re­serve do more to hold rates down, or did the cen­tral bank al­ready err by leav­ing them low for too long, feed­ing the hous­ing and credit bub­bles of re­cent years? As Fed pol­i­cy­mak­ers pre­pare to meet this week to dis­cuss these mat­ters, it’s worth dis­pelling some of the most com­mon mis­con­cep­tions about in­ter­est rates.

The Fed con­trols in­ter­est rates.

1 Yes, the Fed­eral Re­serve can change its fed­eral funds rate— the overnight rate charged on loans be­tween banks— and those shifts af­fect short-term rates on busi­ness loans and con­sumer loans. But long-term in­ter­est rates, such as those on a 10-year Trea­sury bond or on 30-year mort­gages, are de­ter­mined by the mar­kets and are in­flu­enced by in­fla­tion trends, govern­ment bud­get deficits, and the over­all de­mand for and sup­ply of cap­i­tal over time.

The lim­its of the Fed’s pow­ers were ap­par­ent re­cently when it be­gan its sec­ond round of “quan­ti­ta­tive eas­ing” — an ef­fort to lower long-term rates by pump­ing more money into the econ­omy. Those rates did fall in the weeks lead­ing up to the pro­gram’s launch in Novem­ber, but they rose sharply soon after­ward. Why?

First, signs of a strength­en­ing econ­omy prompted many an­a­lysts to raise their growth fore­casts for this year, im­ply­ing that the de­mand for cap­i­tal will rise as well— and greater de­mand for cap­i­tal trans­lates into higher rates. Sec­ond, the tax-cut deal that the White House and con­gres­sional lead­ers struck in De­cem­ber will boost govern­ment bor­row­ing this year, adding to the de­mand for cap­i­tal. Fi­nally, some in­vestors worry that, as the econ­omy gains mo­men­tum, the Fed’s pro­gram could lead to ris­ing in­fla­tion, and such fears could lead to higher in­ter­est rates.

Low in­ter­est rates are here to stay.

2 Not so. In­ter­est rates are headed higher, and not just be­cause the Fed will even­tu­ally raise short-term rates once the econ­omy speeds up. Our re­cent re­search shows that the global de­mand for cap­i­tal is ris­ing fast as emerg­ing mar­kets em­bark on one of the biggest build­ing booms in his­tory. Rapid eco­nomic growth and ur­ban­iza­tion in de­vel­op­ing na­tions, par­tic­u­larly China, is fu­el­ing de­mand for hous­ing, roads, ports, wa­ter and power sys­tems, ma­chin­ery, and equip­ment. Global in­vest­ment de­mand could rise from $11 tril­lion to­day to $24 tril­lion per year by 2030.

Mean­while, global sav­ing is un­likely to rise as fast, as coun­tries around the world spend more on pen­sions, health care and other needs of their ag­ing pop­u­la­tions. In some fore­casts, global sav­ing will fall short of in­vest­ment de­mand by as much as $2.4 tril­lion in 2030. And be­cause, by def­i­ni­tion, sav­ings and in­vest­ment must equal each other, the gap will push in­ter­est rates up.

U.S. pol­i­cy­mak­ers should keep rates low so con­sumers will spend more and boost the econ­omy.

3 Amer­i­can house­holds are now sav­ing more than they were dur­ing the re­cent credit bub­ble; the per­sonal sav­ings rate in­creased from 2 per­cent in 2007 to nearly 6 per­cent in 2010. Not only does this help peo­ple save for re­tire­ment, it’s also good for the nation’s long-term eco­nomic health: Higher na­tional sav­ings will help fund more na­tional in­vest­ment. If any­thing, pol­i­cy­mak­ers should en­cour­age con­sumers to save even more.

But wouldn’t more per­sonal sav­ing dampen eco­nomic growth? Not if cor­po­ra­tions and the govern­ment in­crease in­vest­ments that ex­pand the nation’s ca­pac­ity to pro­duce more and bet­ter goods and ser­vices. We’ve in­vested too lit­tle in the past, par­tic­u­larly in in­fra­struc­ture. The Amer­i­can So­ci­ety of Civil En­gi­neers es­ti­mates that the United States needs to spend an ad­di­tional $2.2 tril­lion over five years— on top of our cur­rent $400 bil­lion an­nual in­vest­ment— on trans­porta­tion, wa­ter, en­ergy, schools, waste dis­posal and pub­lic parks to re­new the nation’s crum­bling in­fra­struc­ture and help meet grow­ing de­mand.

These kinds of in­vest­ments would pro­vide ad­di­tional fuel for eco­nomic growth, off­set­ting slower gains in con­sumer spend­ing. And now is the time to start, while in­ter­est rates are still near his­tor­i­cally low lev­els.

The mort­gage in­ter­est de­duc­tion is nec­es­sary to sup­port the hous­ing mar­ket and the econ­omy.

4 Hardly. The de­duc­tion is a fa­vorite among home­own­ers, real es­tate agents and len­ders, but its broader eco­nomic ben­e­fits are de­bat­able.

Un­der cur­rent law, tax­pay­ers can deduct their in­ter­est pay­ments on up to $1 mil­lion in mort­gage debt on both their pri­mary res­i­dences and their sec­ond homes, and can also deduct their in­ter­est pay­ments on up to $100,000 in home-eq­uity loans. The law thus low­ers the cost of home­own­er­ship and cre­ates in­cen­tives to take on ex­tra mort­gage debt— spurring the real es­tate and fi­nance in­dus­tries as well as con­sumer spend­ing.

But these gains come at a cost: The de­duc­tion low­ers fed­eral rev­enues (by a pro­jected $104 bil­lion in 2011), thereby adding to the bud­get deficit. It also en­cour­ages house­holds to take on more debt than they would oth­er­wise and thus helped feed the hous­ing bub­ble that led to the fi­nan­cial cri­sis. Canada, by con­trast, has no such mort­gage tax de­duc­tion, and its hous­ing mar­ket is health­ier and less lever­aged, avoid­ing U.S.style booms and busts. The pro­posal by Pres­i­dent Obama’s fis­cal com­mis­sion to sharply limit the mort­gage in­ter­est de­duc­tion was a step in the right di­rec­tion.

Higher in­ter­est rates are bad for the econ­omy.

5 Ac­tu­ally, in sev­eral ways, some­what higher in­ter­est rates would be bet­ter for the econ­omy than the ex­tremely low rates of re­cent years. They would ben­e­fit savers (par­tic­u­larly re­tirees and pen­sion funds) and there­fore en­cour­age greater house­hold sav­ing.

They would also limit fi­nan­cial bub­bles, re­strain­ing spec­u­la­tive and heav­ily lever­aged in­vest­ment while en­cour­ag­ing more in­vest­ment that would ac­tu­ally raise the econ­omy’s po­ten­tial growth rate, such as ex­pand­ing the coun­try’s broad­band net­work, de­vel­op­ing new green tech­nolo­gies and re­build­ing ag­ing in­fra­struc­ture.

Higher rates also would fo­cus ex­ec­u­tives’ at­ten­tion on the re­turn that com­pa­nies earn on their cap­i­tal, prod­ding them to make sure they get more bang for each buck. This could boost the nation’s pro­duc­tiv­ity, which is the key to rais­ing stan­dards of liv­ing over time.

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