What Drives Interest Rates? Old Question Is Key to New Economics

Stripped down to basics, the new consensus in economics goes like this: It’s fine for governments to borrow and spend more money -- so long as they can get hold of it cheaply.

But as a guide to policy, the doctrine has a blind spot. Because even after arguing the point for a couple of centuries, economists find it hard to pin down what drives long-run interest rates -- or predict where they’re headed.

“The greatest area of uncertainty in any forecast is really the forecast of interest rates,” Laura Tyson, a senior economic adviser to the Clinton and Obama administrations, told Bloomberg TV . “The profession has not been great at timing either the direction or the amount.”

Those are crucial questions right now, for governments trying to figure out how much it’s safe to spend on pandemic recovery, and for investors wondering if this year’s surge in sovereign-bond yields is a blip or the start of a new era.

‘More Power’

For years, estimates of future borrowing costs have tended to be too high –- leading to projections of bigger debts, and helping deter public spending. Some worry the opposite could happen now: politicians will grow complacent about low interest rates, borrow and spend too much, then get a nasty surprise when they spike.

But there’s a school of economic thought says that governments and central banks play a bigger role in shaping interest rates than the mainstream acknowledges. Translated into practical terms, that means countries can turn their own borrowing costs into a policy choice, instead of a price that gets discovered in the marketplace.