Long-term interest rates have been surprisingly—and inexplicably—low relative to the path of short-term rates expected by the markets. If the relationship were to return swiftly to something closer to the historical norm—that is, if long-term rates were to rise suddenly—economic growth might slow more than my forecast suggests.

There is also the possibility, however, that housing markets will remain solid—for example, because of support from the continued low level of long-term interest rates. This would then heighten the risk of above-trend GDP growth and the further development of pressures on resources.

The low real interest rates throughout the world over the last several years suggest that the most important factors underlying the recent increase in the U.S. current account deficits have been shifts in the desired net savings by the rest of the world. Reductions in desired U.S. net saving may have played a role as well. But if a fall in U.S. desired saving was dominant, interest rates would have risen, not fallen.

A second possible explanation of the evident decline in the term premium is linked to the increased intervention in currency markets by a number of governments, particularly in Asia. According to this explanation, foreign official institutions, primarily central banks, have invested the bulk of their greatly expanded dollar holdings in U.S. Treasuries and closely substitutable securities, and these demands by the official sector have put downward pressure on yields. This interpretation has some support, including research that I did with two coauthors that found that longer-term yields came under significant downward pressure during episodes of heavy official purchases of dollars in 2004...

However, these observations speak more to the existence of a short-term impact of large purchases and sales--the result of limits to liquidity in the very short run--than to the perhaps more important question of whether those transactions have a lasting effect on yields.

A reasonable conclusion is that the accumulation of dollar reserves abroad has influenced U.S. yields, but reserve accumulation abroad is not the only, or even the dominant, explanation for their recent behavior.

Changes in the management of and accounting for pension funds are a third possible source of a declining term premium. Reforms proposed in the United States, Europe, and elsewhere are widely expected to encourage pension funds to be more fully funded and to take steps to better match the duration of their assets and liabilities. Together with the increased need of aging populations in the industrial countries to prepare for retirement, these changes may have increased the demand for longer-maturity securities. We have seen little direct evidence to date of sizable pension-fund portfolio shifts toward long-duration bonds, at least in the United States. But judging from anecdotal reports, bond investors might be attaching significant odds to scenarios in which pension funds tilt the composition of their portfolios toward such assets substantially over time.

Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards.

Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative.

Finally, the yield curve is only one of the financial indicators that researchers have found useful in predicting swings in economic activity. Other indicators that have had empirical success in the past, including corporate risk spreads, would seem to be consistent with continuing solid economic growth. In that regard, the fact that actual and implied volatilities of most financial prices remain subdued suggests that market participants do not harbor significant reservations about the economic outlook.

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.

Long-term interest rates are not rising because of an increase in inflation expectations, he said, and instead indicate a "vote of confidence" in the expansion.

I do support the Treasury's decision to resume issuance of thirty-year bonds.  Given the large current and prospective federal financing needs, it is prudent to distribute the Treasury's borrowing across the yield curve.  Moreover, long-term interest rates are currently quite low, apparently reflecting in part strong demand among investors for long-term issues.  In these circumstances, it is sensible for the Treasury to accommodate this demand in part by issuing thirty-year securities.

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.

When Alan Greenspan first used the term “conundrum” to describe the surprising behavior of forward interest rates, he was reacting to the decline in forward nominal rates over a period in which the Federal Open Market Committee was raising its federal funds target rate. This behavior of forward rates, the counterpart of which is the behavior of the bond yield curve, looked anomalous both in comparison to observations from past tightening cycles and with what seemed to be strong evidence about the fundamental soundness of the outlook for the real economy. The source of the relatively low level of nominal rates is still a matter of considerable debate. Part of the explanation lies in the decline in expectations of future inflation and uncertainty about future inflation. Part of the explanation may also lie in greater confidence that the secular decline in the variability of economic growth observed over the past two decades in the United States is likely to continue. However, even with the information provided by the development of the market for inflation-indexed government securities, we have less ability than we would like to draw conclusions about what any nominal forward rate means for expectations about the level of future real rates, uncertainty about future real rates, and what those might imply about expectations about future economic activity. This uncertainty makes it harder to assess the appropriate path of monetary policy.

If one were confident that observed imbalances simply reflected a more efficient allocation of the world’s stock of saving to its most productive uses, that relative prices adjust freely in response to changing fundamentals and that economies are flexible and agile in adapting to those changes, then we might also reasonably expect these imbalances to resolve themselves through smooth and gradual adjustments in relative prices and flows of goods and services. These conditions do not fully exist today. We do not yet live in a world of perfect capital mobility, one in which savings move across borders to their most productive use without constraint in the form of capital controls or without distortions affecting the behavior of private actors. Recognizing this is important to understanding both why the U.S. imbalance has grown as large as it has and, perhaps, more importantly why it has been financed with such apparent ease despite obvious concerns about its sustainability...The anomaly is that these imbalances have persisted on a seemingly unsustainable path with relatively low interest rates and very little evidence of rising risk premia.

The demographic shifts underway in the major economies seem to have contributed to an increase in demand for longer-dated fixed income assets to fund growing pension liabilities, and these shifts have been reinforced by actual and anticipated changes in the regulations that affect pension fund managers. These changes may have operated to push up the price and lower the yield on longer maturity bonds, but the effect of these changes seems likely to be small in comparison to the changes in the behavior of forward interest rates.

Even with the broad shift globally to more flexible exchange rates, a substantial part of the world economy now run monetary policy regimes targeted at limiting the variability in their exchange rate against the dollar, or a basket in which the dollar plays a substantial role. Sustaining that objective in the past several years has required a large accumulation of dollar assets...The significant rise in the earnings of the energy exporters, many of whom also run exchange rate regimes that seek to shadow the dollar, has also generated a substantial rise in investments in U.S. assets. A large share of the capital flows to the United States that have financed our current account imbalance come from these official sources. These flows add to other sources of private demand for U.S. assets. At the margin, they put downward pressure on U.S. interest rates and upward pressure on other asset prices. Through this effect, the monetary policy regimes that prevail in parts of the world help explain at least part of the persistence of these anomalies...Research at the Federal Reserve and outside suggests that the scale of foreign official accumulation of U.S. assets has put downward pressure on U.S. interest rates, with estimates of the effect ranging from small to quite significant.

I anticipate that the adoption of a formal inflation objective would result in some, probably modest, further reduction in the level and variability of nominal long-term bond yields.  Adopting a formal inflation objective, and success in achieving that objective, will also enhance policymakers’ ability to pursue other policy objectives, such as conducting countercyclical monetary policy.