Two distinct but overlapping developments appear to be at work in explaining the low level of long-term interest rates: a longer-term trend decline in bond yields and an acceleration of that trend over the period since mid-2004.

The trend reduction worldwide in long-term yields surely reflects an excess of intended saving over intended investment.  This configuration is equivalent to an excess of the supply of funds relative to the demand for investment...As best we can judge, both high levels of intended saving and low levels of intended investment combined to lower real long-term interest rates over the past decade.

The economic forces driving the global saving-investment balance have been becoming manifest over the past decade, so the steepness of the recent decline in long-term yields suggests that something more may have been at work over the past year. According to estimates prepared by the staff of the Federal Reserve Board, a significant portion of the more recent decline appears to have resulted from a fall in term premiums. Such estimates are subject to considerable uncertainty; nevertheless, they suggest that a perceived increase in economic stability in recent years has encouraged risk-takers to reach out to more-distant time horizons.

Over the past year, the Fed has raised the federal funds rate significantly. Normally, long-term interest rates also rise with increases in the expected path for the federal funds rate. But, long-term rates—such as those on 30-year fixed rate mortgages—have actually fallen over the period. This is what Chairman Greenspan has labelled a conundrum because there seems to be no convincing explanation for it.

Some have asserted that our accommodative policy stance in recent years, made necessary by the macroeconomic situation, itself has tended to drive down risk premiums as investors "reached for yield." Notably, however, most risk spreads have remained narrow even as we have been removing policy accommodation.

This decline in long-term rates has occurred against the backdrop of generally firm US economic growth, a continued boost to inflation from higher energy prices, and fiscal pressures associated with the fast approaching retirement of the baby-boom generation.  The drop in long-term rates is especially surprising given the increase in the federal funds rate over the same period.  Such a pattern is clearly without precedent in our recent experience.

Some, but not all, of the decade-long trend decline in that forward [bond] yield can be ascribed to expectations of lower inflation, a reduced risk premium resulting from less inflation volatility, and a smaller real term premium that seems due to a moderation of the business cycle over the past few decades.

The effective productive capacity of the global economy has substantially increased, in part because of the breakup of the Soviet Union and the integration of China and India into the global marketplace.  And this increase in capacity, in turn, has doubtless contributed to expectations of lower inflation and lower inflation-risk premiums.

The trend reduction worldwide in long-term yields surely reflects an excess of intended saving over intended investment...What is unclear is whether the excess is due to a glut of saving or a shortfall of investment.

Since the mid-1990s, a significant increase in the share of world gross domestic product (GDP) produced by economies with persistently above-average saving--prominently the emerging economies of Asia--has put upward pressure on world saving.  These pressures have been supplemented by shifts in income toward the oil-exporting countries, which more recently have built surpluses because of steep increases in oil prices.

Exceptionally low interest rates on ten-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding, home turnover, and particularly in the steep climb in home prices.  Whether home prices on average for the nation as a whole are overvalued relative to underlying determinants is difficult to ascertain, but there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels.

Historically, it has been rising real long-term interest rates that have restrained the pace of residential building and have suppressed existing home sales, high levels of which have been the major contributor to the home equity extraction that arguably has financed a noticeable share of personal consumption expenditures and home modernization outlays.

Demographers assure us that aging baby boomers, a positive rate of family formation, and continued immigration into the U.S. are at least partially responsible for the relative rise in residential real estate prices. Economists’ best guess is that the underlying fundamentals indicate that housing markets and housing prices should begin to stabilize as the so-called conundrum fades and mortgage interest rates rise.

I would not try to manage the yield curve as a policy maker...I think that our goal...is to focus on the real economy and make sure the environment of stable prices stays in place.

Long-term interest rates are most likely low by historical standards because expectations of future inflation are very well maintained right now.