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How low might interest rates go?

Whether individuals, private businesses or public entities, borrowers of all types have enjoyed the extremely low interest rate environment of the past several years. As can be seen in Exhibit 1, the yield on 30-year Treasury bonds, a common measure of interest rate levels, has steadily declined for the past six years. In mid-August of this year, the 30-year Treasury was at a two-decade low of 6.30 percent. The average yield between 1980 and 1993 was 9.86 percent.

Among those borrowers benefiting from the low interest rate environment have been state and local governments. For example, a record amount of $235 billion in long-term, tax-exempt debt was issued during 1992. That number very likely will be surpassed by tax-exempt bond issuance in 1993. Through June, $145 billion of long-term, tax-exempt bonds have been issued. The boom in debt issuance in 1993 is very similar to what was driving the market last year--refundings of previously issued debt. In 1992, 50 percent of long-term debt issuance was for refundings. Through the first half of 1993, approximately 66 percent was for refundings. Many market observers expect the volume of tax-exempt refundings to decrease, however, based on the belief that most of the refundings that made sense on an economic basis already have been completed or will be completed in the months ahead. Of course, there is potential for an additional wave of refundings should interest rate levels continue to fall.

In addition to refunding possibilities, state and local government finance officials are keeping a keen eye on interest rate levels as they consider various capital financing plans. Some are contemplating moving financing plans forward to take advantage of the current low interest rates in the tax-exempt market. Others are exploring various forward financing plans that would allow them to lock-in today's attractive rates for projects that may not get underway for many months. Government finance officials on the investment side of the market also are interested in the future movement of interest rates. Their task of attaining high investment returns while ensuring the safety and liquidity of public funds has been made more difficult by low interest rate levels.

What Is Ahead for the Economy?

There will continue to be uncertainty regarding the overall economy as the Clinton health care program is defined and implemented over time. One should note that the health care industry, approximately 15 percent of the American economy, has been downsizing and is likely to continue in this mode. Setting aside the risk associated with developments in health care, there is a strong feeling among economists that interest rates will remain at relatively low levels in 1994.

What are some of the macroeconomic factors to be considered in evaluating where interest rates may move in the year ahead? One is the general level of economic activity as measured by gross domestic product (GDP) and employment. As is often the case, there currently are mixed signals present in the economy. Real GDP for the first half of 1993 was below 2 percent (nominal GDP was slightly above 4 percent); however, the employment situation has improved slightly during the past year. Table 2 indicates a reduction in the national unemployment rate from 7.7 percent in the third quarter of 1992 to 7.0 percent in the second quarter of 1993. Furthermore, there has been recent evidence of increasing consumer confidence in the economy. Consumer demand in real terms increased by 3.8 percent during the second quarter of the year. Despite this evidence of improving domestic economic activity, there is little concern that the economy is in danger of overheating, which might cause inflationary pressures and upward movement in interest rates. The summer floods are likely to contribute to food price inflation; however, the overall inflation rate is expected to be in the low side of the 3 to 4 percent range through next year.

Forecasting interest rates is difficult to do. Based on their current levels, it is easy to predict that interest rates will increase sometime in the future. Of interest to most, however, is the general level of interest rates in the near term--the next 12 months. Monetary policy is unlikely to turn restrictive given the contractionary fiscal policy of higher taxes and lower spending recently passed in Washington. Given the current state of the economy and the fiscal and monetary policy currently in place, many economists believe interest rates in the months ahead will continue to be at or near record low levels. The 30-year Treasury is expected to be in the bottom half of the 6 to 7 percent range, and high-quality, tax-exempt issuers may expect to continue to enjoy long-term borrowing costs in the 5 to 6 percent range.




J.B. KURISH, director of GFOA's Government Finance Research Center, prepared this article.
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Kurish, J.B.
Publication:Government Finance Review
Date:Oct 1, 1993
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