I see the decline in mandate-consistent real interest rates as grounded in an increase in the demand for, and a fall in the supply of, safe financial investment vehicles. Importantly, I see these changes as likely to be highly persistent.
There are many factors underlying the increased demand for safe assets. I’ll discuss three that strike me as particularly important: tighter credit access, heightened perceptions of macroeconomic risk and increased uncertainty about federal fiscal policy.

In terms of credit access, I don’t think that it’s controversial to say that credit access is more limited than in 2007. What is less generally realized, I think, is that restrictions on households’ and businesses’ ability to borrow typically lead them to spend less and save more.

I can best illustrate this point through an example. Consider a household that wants to purchase a new home. In 2007, that household could have received a mortgage with a down payment of 10 percent of the purchase price, or even lower. In 2014, that same household is considerably more likely to need a down payment of 20 percent. These tighter mortgage standards mean that, to buy a similarly priced house, the household needs to first acquire more assets.

Thus, the demand for safe assets has risen because of tighter limits on credit access. It has also risen because of households’ and businesses’ assessments of macroeconomic risk… [I]n the wake of the Great Recession and the Not-So-Great Recovery, the story is different. Now, more workers see themselves as being exposed to the risk of persistent deterioration in labor incomes. More businesses see themselves as being exposed to the risk of a radical and persistent downshift in the demand for their products. These workers and businesses have an incentive to accumulate more safe assets as a way to self-insure against this enhanced macroeconomic risk.

The federal fiscal situation is the third key source of elevated uncertainty. The federal government faces a long-run disconnect between its overt commitments and the baseline path of federal tax collections. This disconnect can only be resolved by raising taxes and/or cutting the long-run arc of spending… The prospect of reductions in Medicare, Medicaid or Social Security gives some households an incentive to demand more safe assets as a way of replacing those lost potential benefits.

I’ve argued that, due in part to tighter credit access and higher uncertainty, the demand for safe financial assets has risen since 2007. At the same time, the global supply of assets perceived as safe has also fallen. Americans—and many others around the world—thought in 2007 that it was highly unlikely that American residential land, and assets backed by land, could ever fall in value by 30 percent. Not anymore. Similarly, investors around the world viewed all forms of European sovereign debt as a safe investment. Not anymore.

Thus, the FOMC is confronted with a greater demand for safe assets and tighter supply of safe assets than in 2007. These changes in asset markets mean that, at any given level of real interest rates, households and businesses spend less. Their decline in spending pushes down on both prices and employment. As a result, the FOMC has to lower the real interest rate to achieve its objectives.2

I often hear that the FOMC has created a low interest rate environment that is harmful for savers and others. In my view, like savers, the FOMC is being forced to make unusual decisions by an unusual economic environment that is not of its own making. The FOMC has been confronted with a significant increase in safe asset demand and a significant fall in safe asset supply. Faced with these changes, the Committee can only achieve its macroeconomic objectives by taking actions to push down the real interest rate. Indeed, as I argued earlier, the subdued outlook for prices and employment suggests that the FOMC’s actions have not lowered the real interest rate sufficiently.

What about the future? The passage of time will ameliorate these changes in the demand for and supply of safe assets—but only partially. Any long-run forecast has enormous attendant uncertainties. But I expect that for a considerable period of time—possibly the next five years or more—credit market access will remain limited relative to what borrowers had available in 2007. I expect that many workers and businesses will remain more concerned than in 2007 about the risk of a large adverse shock. And I also expect that businesses will continue to feel a heightened degree of uncertainty about taxes and households will continue to feel a heightened degree of uncertainty about the level of federal government benefits. These considerations suggest that, for many years to come, the FOMC will have to maintain low real interest rates to achieve its congressionally mandated goals. I see this conclusion as broadly consistent with the April FOMC statement, which predicts that the target fed funds rate will remain low for some time after inflation and employment are near mandate-consistent levels.

Well, on the saving glut, I would like to mention that there were a number of speakers today who talked about — going back to Carmen Reinhart, who talked about the current accounts and its role in precipitating the crisis.

And I — this is one of the things that I — was a theme of my commentary before the crisis, which was the idea that the capital inflows that we were seeing — related, of course, to our large trade deficit, but also to the international demand for dollar reserves — was in fact a potentially destabilizing factor, and certainly was in any case making financial conditions easier than they otherwise would have been.

Instead, the main causes of the crisis originated in the financial sector and stemmed from a widespread underappreciation and underpricing of risk. Failures of risk-management systems, incentive problems in securitization and compensation structures, and regulatory shortcomings and gaps led to a vulnerable, overleveraged financial system with inadequate capital and liquidity buffers. These problems were amplified by the eagerness of U.S. households to take on huge amounts of mortgage debt and of lenders to advance them the credit, justified by overly optimistic expectations for house price appreciation as the real estate boom progressed.

But these financial sector problems were enabled, if not encouraged, by developments in the global economy. The capital outflows associated with the persistent current account surpluses were large even in net terms and, combined with relatively restrained business capital spending in many advanced economies (including the United States), put downward pressure on real interest rates globally.⁴ 

From a purely theoretical perspective, there is no compelling reason to believe that low real interest rates, by themselves, pose a particular risk to global economic and financial stability, as real interest rates should be driven by underlying forces to balance the global demand for saving and investment. Capital inflows from abroad can be beneficial if they are invested prudently. But in an environment in which the financial sector is prone to excess and the supervisory structure does not respond sufficiently, the interaction of low interest rates and financial vulnerabilities can clearly be dangerous. Notably, the generally stable macroeconomic environment that prevailed before the crisis may have exacerbated this problem, as it contributed to overly sanguine perceptions of risk.

Rather than financing productive business investment, capital inflows too often facilitated spending on housing and consumer goods. This circumstance was particularly true in the United States, where an innovative and entrepreneurial financial system aggressively competed for the opportunity to channel this capital to customers, in part by devising new and complex mortgage products. The resulting availability of funds and reduced interest rates boosted asset prices, particularly in the housing sector, and market participants assumed housing prices would continue to rise.

Some observers have attributed the bubbles observed in some asset prices in recent years to a decades-long downward trend in real interest rates. In this view, the decline in interest rates has caused investors to reach for yield by purchasing riskier assets with higher returns, driving the prices on riskier assets above fundamental values... From my perspective, the decisions the central banks were making about their policy rates were shaped by the underlying determinants of the balance of saving and investment, including, in the past decade or so, the high saving propensities of the newly emerging Asian economies and the sluggish rebound in investment globally after the recession early last decade. Nonetheless, it is important that we understand the reasons for the decline in average real rates and whether low rates are likely to persist--and that very tough problem is the extra credit assignment. For one thing, as the economic expansion gains traction and central banks back off the current highly accommodative stance of policy, policymakers will need to understand how the longer-term trend in real rates has influenced the point at which the policy rate becomes restrictive...

Like water seeking its level, saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates remained low.

The global imbalances were the joint responsibility of the United States and our trading partners, and although the topic was a perennial one at international conferences, we collectively did not do enough to reduce those imbalances. However, the responsibility to use the resulting capital inflows effectively fell primarily on the receiving countries, particularly the United States... In certain respects, our experience parallels that of some emerging-market countries in the 1990s, whose financial sectors and regulatory regimes likewise proved inadequate for efficiently investing large inflows of saving from abroad. When those failures became evident, investors lost confidence and crises ensued. A clear and highly consequential difference, however, is that the crises of the 1990s were regional, whereas the current crisis has become global.

However, as subsequent events have demonstrated, the problem was much broader than subprime lending. Large inflows of capital into the United States and other countries stimulated a reaching for yield, an underpricing of risk, excessive leverage, and the development of complex and opaque financial instruments that seemed to work well during the credit boom but have been shown to be fragile under stress.

The financial crisis, I think, is the unwinding of what was an excessive credit boom in the years up through middle of last year.  For a variety of reasons global interest rates were quite low, and that generated strong efforts to reach for yield, as it was said, and so there was a lot of risk taking. There was a lot of financial innovation. And the result I think was some unsustainable investment, some unsustainable asset creation.

We've seen the unwinding of that. That is in some ways positive. But on the other hand, the contraction of credit and the restriction of financing that we've seen associated with that has slowed the economy and has had adverse effects on families, as you indicate.    We are trying to find a financial stability. The Fed is working as best we can to stabilize the economy and to stabilize the financial system.

From the Q&A session

At this point conclusions about cause and effect are more speculation than science. But I am persuaded that the liquidity conditions created by foreign-owned dollar surpluses trying to find an investment home in this country contributed to markets' recent unstable conditions.

I am also persuaded these financial imbalances are not likely to disappear in the foreseeable future. We must live with them, and policymakers must be mindful of them.

Since I discussed these issues in March 2005, real interest rates have reversed some of their previous declines.  For example, in the United States, real yields on inflation-indexed government debt averaged 2.3 percent in 2006 as compared with 1.85 percent in 2004.  In the past few weeks, that yield has averaged about 2.4 percent.  Inflation-adjusted yields in other industrial countries have also started to move back up after falling in 2005.⁸      

How does this all fit together?  My reading of recent developments is that although some of the details have changed, the fundamental elements of the global saving glut remain in place. ..

Further increases in net capital flows from the developing economies, all else being equal, should have further depressed real interest rates around the world.  But as I have noted, in the past few years, real interest rates have moved up a bit.  This increase does not imply that the global saving glut has dissipated.  However, it does suggest that, at the margin, desired investment net of desired saving must have risen in the industrial countries enough to offset any increase in desired saving by emerging-market countries...

Once again, however, I do not want to rely exclusively on this line of explanation for the behavior of long-term real interest rates, as other factors have no doubt been relevant.  In particular, term premiums appear recently to have risen from what may have been unsustainably low levels, in part because of the greater recent volatility in financial markets and investors' demands for increased compensation for risk-taking.

An often overlooked implication is that, all else equal, an increase in the growth rate of productivity will tend to put upward pressure on real interest rates.  But in fact we have not seen the predicted rise in real rates.  Of course, we do not live in the world of simple economic models so all other things are not equal.  In particular, I believe one reason is that sound economic policies have created a more stable economic environment, and with that has come low and stable inflation and an ongoing desire by foreigners to invest in the United States to reap higher returns associated with higher productivity growth than may be available in their economies.        

The savings glut story helps to explain the real component of low bond yields as well as the pattern of global capital flows, which was Chairman Bernanke’s focus. Another factor behind declining real yields in some emerging markets is that their improved fiscal situation not only increases national saving but also calms fears about the ability of governments to service their debt.

Among the international factors cited as influences on U.S. interest rates in the past few years is the global saving glut. Unusually high saving might hold down the level of real interest rates, but there is no reason why there should be an effect on the shape of the term structure. In any event, it appears that real interest rates are returning to a more normal level in the United States.

Given the global nature of the decline in yields, an explanation less centered on the United States might be required. About a year ago, I offered the thesis that a "global saving glut"--an excess, at historically normal real interest rates, of desired global saving over desired global investment--was contributing to the decline in interest rates. In brief, I argued that this shift reflects the confluence of several forces. On the saving side, the factors include rapid growth in high-saving countries on the Pacific Rim, export-focused economic development strategies that directly or indirectly hold back the growth of domestic demand, and the surge in revenues enjoyed by oil producers. On the investment side, notable factors restraining the global demand for capital include the legacy of the Asian financial crisis of the late 1990s, which led to continuing sluggishness in investment in some of those economies, and the slower growth of the workforce in many industrial countries. So long as these factors persist, global equilibrium interest rates (and, consequently, the neutral policy rate) will be lower than they otherwise would be.

I attribute the relatively low level of long-term rates generally to several factors, including a tendency in recent years for global saving to exceed the amount of potential capital investments, yielding historically normal rates of return as well as relatively low term premiums to interest rates to compensate investors for interest rate risk.  In the unlikely event that any of these factors tended to push real long-term yields to levels that appeared to be incompatible with our macroeconomic objectives, the Federal Reserve would respond by adjusting the stance of monetary policy appropriately.

Savings glut - perhaps the terminology was unfortunate. In fact, the issue is the amount of global savings relative to the amount of global investment opportunities.  The most striking change in the past 10 or 12 years has been in emerging markets, particularly East Asia, which 10 to 12 years ago were large net borrowers on international capita markets and now are even much larger net lenders. And if you try to take apart the reasons for that change it's partly their very high rate of saving, but the change itself is due more to declines in investment, outside of China.  So part of the cause of this so-called global savings glut, I believe, is the financial crises of the late '90s, which reduced inflows of investment capital expenditure in some of these emerging market economies.  The oil producers also are playing a role here, because they are receiving all this oil money. They don't have sufficient opportunities at home for investment and therefore they too are recycling funds into the global capita markets.