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Decomposition Of Long Term Rates

So, why are long-term interest rates currently so low? Ben Bernanke recently went in to detail about the low long term rates. Here is the synopsis with additional commentary.

To help answer this question, it is useful to decompose longer-term yields into three components: one is reflecting expected inflation over the term of the security; another capturing the expected path of short-term real, or inflation-adjusted, interest rates; and a residual component known as the term premium.

In short all three measures have been falling since the financial crises. Fed has attributed that out of one component, expected short term rates; Fed has direct control on it. Fed has controlled the short term rates. Fed has reduced the short term borrowing rates to Zero. It is trying to influence the term premium. It has also been buying long term bonds, which had the effect of reducing the term premium to certain extent. Additionally the rates between all the developed countries have been closely following each other for past decade. This may have reduced the term premium.

In previous blogs, I had mentioned that long term rates across the developed countries have followed each others, in spite of different economic policies, deficits, governments. The common factor has been falling inflation.

In the entire lecture by Ben Bernanke, Deficits have not been mentioned even once. Ben Bernanke has mentioned that there is wide variation in the forecast of long term rates in the coming years. This is probably due to differing views about the inflation might increase and disappearance of term premium and increase in the short term interest rates. In 4 years from now the variation in the long term rates is more than 175 bps.