Do Low Interest Rates Ensure High Asset Prices?

Asset prices– stocks, commercial real estate, and even oil – are, historically, at high levels around the world. Although history is often a good predictor of future trends, every now and then something fundamental changes that makes for a new pattern. The important question now is whether today’s high asset prices are the result of some such fundamental development, or whether bubbles have formed.

One oft-heard justification for high asset prices is that real (inflation-adjusted) long-term interest rates are very low. But investors should be wary of this argument. It may sound plausible, but it is hardly conclusive, and, more importantly, it certainly does not tell us that high prices are sustainable.

It is, of course, true that real long-term interest rates have declined quite markedly – not suddenly and not only recently, but at a fairly steady pace for more than twenty years. According to the IMF, world real long-term interest rates peaked at nearly 7% on average in 1984, and fell to just below 2% by 2004. There were some ups and downs along the way, but the overall trend has been downward, and the magnitude of the decline – nearly five percentage points – is striking.

Ben Bernanke, the Chairman of President George W. Bush’s Council of Economic Advisors and a likely candidate to succeed Alan Greenspan as the Federal Reserve’s chairman in January, has called the decline in real interest rates over just the last decade a “global savings glut.” It is not that there is “too much” saving around the world today, but that the amount of saving has been high enough that returns, as measured by real interest rates, are a lot lower than they once were. In a March 2005 speech, Bernanke argued that this “glut” helps explain several features of the American economy, possibly including the enormous fiscal and trade deficits.