L o w I n t e r e s t R a t e s E n c o u r a g e I n v e s t me n t

a n d S t i mu l a t e C o n s u me r S p e n d i n g

Interest Rates

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CHAPTER

162

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The U.S. economy performed well from the early

1990s through 2007. Economic growth was posi-

tive, unemployment was fairly low, and inflation

remained under control. One reason for the

economy’s good performance was the low level

of interest rates over most of that period, with

the rate on 10-year Treasury bonds generally at

or below 5%, a level last seen in the 1960s, and

rates on most other bonds correspondingly low.

These low interest rates reduced the cost of capi-

tal for businesses, which encouraged corporate

investment. They also stimulated consumer

spending and helped produce a massive growth

in the housing market.

The drop in interest rates was due to a num-

ber of factors—low inflation, foreign investors’

purchases of U.S. securities (which drove their

rates down), and effective management of the

economy by the Federal Reserve and other gov-

ernment policy makers. However, some shocks

hit the system in 2007, including $100 per barrel

oil and massive write-offs by banks and other

institutions that resulted from the subprime mort-

gage debacle. Higher oil prices and a weakening

dollar could lead to higher inflation, which, in

turn, would push interest rates up. Likewise, the

growing federal budget deficit, combined with

the weakening dollar, could cause foreigners to

sell U.S. bonds, which would put more upward

pressure on rates. At the same time, though, the

economy seems to be weakening, which has led

the Federal Reserve to lower its key short-term

rate in hopes of staving off a general recession. So

some forces are trying to drive rates higher, but

other forces are operating to keep rates low.

Because corporations and individuals are

greatly affected by interest rates, this chapter

takes a closer look at the major factors that deter-

mine those rates. As we will see, there is no single

interest rate—various factors determine the rate

that each borrower pays—and in some cases,

rates on different types of debt move in different

directions. For example, in the aftermath of the

recent subprime mortgage crisis, investors

rushed to put their money in liquid securities

with little or no default risk. This “flight to quality”