As an example, one significant conundrum in financial markets currently is the recent decline of forward short-term rates at long time horizons to extremely low levelsfor example, the 1-year nominal rate, 9 years forward is about 3 percent currently. My staffs analysis attributes this decline almost entirely to lower term premia. In this case, the fact that market participants have set forward rates so low has presumably led to a more accommodative set of financial market conditions, such as the level of bond yields and the equity markets valuation, that are more supportive to economic growth. If such compression in expected forward short-term rates were to persist even after the FOMC begins to raise short-term interest rates, then, all else equal, it would be appropriate to choose a more aggressive path of monetary policy normalization as compared to a scenario in which forward short-term rates rose significantly, pushing bond yields significantly higher.

Figure 16 highlights how low 10-year Treasury rates have fallen recently. Japans experience and now Europes current situation both indicate that indifference to very low inflation rates can generate a significant loss of confidence in the ability of a central bank to hit its inflation goal. It is hard to reconcile the market evidence a 10-year German bond trading around 85 basis points and a 10-year Japanese bond trading below 50 basis points with the publicly announced inflation targets. Bond market evidence suggests that investors have little expectation that 10-year average inflation rates will be anywhere close to their publicly announced targets.

Everyone agrees that it is long-term interest rates and mortgages that ultimately determine the demand for homes and hence the price. What became clear in the early part of this decade is that central banks, not only the Fed, . . . began to lose control over long-term interest rates. That was a major issue in 2004. The Federal Reserve started to raise short-term rates very significantly and found that instead of long-term rates rising with them in unison, it failed . . . I call it the conundrum. What the conundrum was was evidence that long-term interest rates were being dominated by long-term forces.

On the power of the Fed

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.

I have argued that globalization, deregulation, and financial innovation, in part spurred by recent experiences of high inflation, have fostered currency competition that has led to improved central bank performance and, hence, the reduction of inflation worldwide. The resulting enhancement of central bank governance and credibility has allowed the development of long-term bond markets in many countries and the flattening of yield curves around the globe.

This flattening of the yield curve is happening not only in the United States; it is, in fact, a global phenomenon. There has been significant flattening or inversion of the yield curve in the United Kingdom, Canada, and Japan, just to name a few.

This is not surprising once we realize that the Great Moderation and the decrease in inflation expectations are also global phenomena. Since the 1980s, the median inflation rate for advanced economies has declined from 7 percent to 2 percent and the volatility of inflation has declined as well. Over the same period, the median inflation rate has fallen from 9 percent to 4 percent in emerging markets.

So I would suggest that, going forward, as you think about the kind of environment you are going to be in, you may want to anticipate a world where, on average, the spread between short-term rates and long-term rates is likely to be smaller than it has been in some recent periods.

I anticipate that the yield curve is likely to be flatter, on average, than at comparable points in past business cycles. This is not to say that the yield curve is going to be inverted all the time, but, on average, I believe the curve will be flatter. My case for a flatter yield curve is based on two premises: first, inflation and inflation expectations are likely to be lower and more stable, and hence, the inflation premium will be smaller than in the past; and second, inflation and the real economy are likely to be less volatile, so the risk premium will be smaller.

Third, liquidity in U.S. markets also increased significantly in recent years due to increased international capital flows. These flows to the United States from global investors lead to higher liquidity by increasing capital available for investment and facilitating greater transfer and insurability of risk. A recent report by McKinsey & Company estimated that aggregate international capital flows amounted to $6 trillion in 2005--almost triple the volume a decade earlier--and that one-quarter of the worldwide volume flowed through the United States.

The current low level of long-term yields in the United States and other advanced economies is widely acknowledged as somewhat of a puzzle, or, to use former Chairman Greenspan's term, a conundrum. Of course, flat and even inverted yield curves in advanced economies are nothing new. We know that the short end of the yield curve is dominated by monetary policy and cyclical factors.

...To some extent, low forward rates may reflect a persistent decline in expected future real rates of interest or in the real term premium. Chairman Bernanke has suggested that an excess of ex ante global saving relative to global investment has held down real interest rates around the world.

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.

Overall, the combination of lower and less volatile inflation around the world has led to a reduction in inflation expectations and lower perceived inflation risk, hence a lower inflation uncertainty premium in long rates. I believe that these factors have been important contributors to the lower long-term yields and the flattening of yield curves, particularly in emerging markets.

It is also hard to assess the degree to which the current constellation of global monetary conditions has influenced the behavior of long-term interest rates. This makes it harder to assess the appropriateness of the current stance of monetary policy. And it may also mask some of the pressures on risk premiums we might expect to see given the deterioration of the U.S. long-term fiscal situation and the magnitude of the U.S. current account imbalance.

I’ve emphasized the importance of interest-rate expectations for shaping the yield curve and believe that the rate expectations story explains most of what we’ve observed. But there are no doubt other forces at work. It appears that the term premium in long rates fell as the funds rate target increased. One likely reason that the term premium fell in the first year and a half of this tightening cycle is that the market understood the path that short-term interest rates would take in the tightening cycle that began in late June 2004. That predictability reduced the risk of holding longer-term bonds.

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.