04 October 2008

Interest Rates

Greg Mankiw asks why real interest rates are rising. Short term Treasury bill yields are very low (because of increased demand for safe assets) but the yields on 5 year government bonds (inflation adjusted) are rising. He says "It's a puzzle."

It sort of is. I'll admit now that I don't know much about how rates typically move together and my simple conjecture is probably inadequate, but it's the best thing I can think of off the top of my head so I'm going to make it.

There's obviously great uncertainty out there about what's going to happen in the near future and in the medium-run/long-run as a result of the crisis we're in and the attempted rescue by the federal government. That said, even though 5 year government bonds are probably a pretty safe bet, I would think that most savers want to maintain liquidity right now. A 3 month T-bill is a much better purchase compared to bonds considering that nobody knows what's going to happen over even the next few months, let alone 5 years (Even though the bonds are inflation adjusted people may be so freaked out right now that they are only concerned about the return of their money and not the return on it [thanks to Mark Twain for that phrase]). As a result, demand for longer term assets is not as strong as that for very short-term assets such as T-bills. People holding longer term assets may actually be selling off and putting their cash into the T-bills.

Adidas has a good slogan for the current times: Impossible is Nothing. We've seen things happen over the past year that basically had a P(0) or damn close to it; so why would faith in the government's going concern not be shaken. It's not very likely, but there is that slight chance that the government might not be able to pay back those 5 year bonds, and with all the fear out there right now people are considering such a default more seriously.

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