Low Interest Rates and High Asset Prices: An ...

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ROBERT J. SHILLER

Yale University

Low Interest Rates and High Asset

Prices: An Interpretation in Terms of

Changing Popular Economic Models

MANY HAVE NOTED THAT we appear to be living in an era of low long-term

interest rates and high asset prices. Although long-term rates have been

increasing in the last few years, rates so far in the twenty-first century are

still commonly described as low, in both nominal and real terms, compared

with historical averages or with a decade or two ago. Meanwhile stock

prices, home prices, commercial real estate prices, land prices, and even oil

and other commodity prices are said to be very high.1 The two phenomena

appear to be connected: elementary finance theory states that if the long-term

real interest rate is low, the rate of discount used to determine present values

will also be low, and hence present values should be high. This pair of phenomena, connected through the present-value relation, is often described

as one of the most powerful forces operating on the world economy today.

In this paper I will critique this common view about interest rates and

asset prices. I will question the accuracy and robustness of the ¡°low long

rates, high asset prices¡± description of the world. I will also evaluate a popular interpretation of this situation, namely, that it is due to a worldwide

regime of easy money. I will argue instead that changes in both long-term

interest rates and asset prices seem to have been tied up with important

changes in the public¡¯s ways of thinking about the economy. Rational expectations theorists like to assume that everyone agrees on the model of the

economy, which never changes, and that only some truly exogenous factor,

The author is indebted to Tyler Ibbotson-Sindelar for research assistance.

1. See also Shiller (2007) on real estate prices, written concurrently with this paper.

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like monetary policy or technological shocks, moves economic variables.

Economists then have the convenience of analyzing the world from a stable

framework that describes consistent thinking on the public¡¯s part. But an odd

contradiction here is rarely pointed out: the economists who propose these

rational expectations models are themselves regularly changing their models

of the economy. Is it reasonable to suppose that the public is stably and consistently behind the latest incarnation of the rational expectations model?

I propose that the public itself, largely independently of economists,

changes its thinking about the economy over time, and indeed that these

changes in popular economic models have been dramatic. I further propose

that these changes in popular thinking have driven both long-term rates

and asset prices and should be central to our understanding of the large

asset price movements we have seen.2

I will begin by presenting some stylized facts about the level of interest

rates (both nominal and real) and the level of asset prices in the world.

Next I will consider some aspects of the public¡¯s understanding of the

economy, including common understandings of liquidity, the significance

of inflation, and real interest rates, and how these have impacted both asset

prices and interest rates. This will lead me to conclude that the relation

between asset prices and either nominal or real interest rates is very tenuous,

and clouded from definitive econometric analysis by this continual change

in difficult-to-observe popular models.

Changes in Decade-Long Trends in Long-Term Interest Rates

Figure 1 plots nominal long-term (roughly ten-year) interest rates on

government bonds for four countries and the euro area since 1950.3 With

the exception of India, an example of an emerging economy, rates in all of

these countries have been on a massive downtrend since the early 1980s,

and even in India rates have been falling since the mid-1990s. The low point

for long-term rates over this period appears to have been around 2003,

but, broadly speaking, the upward movement since then has been small.

2. The concept of a popular economic model is discussed in Shiller (1990).

3. The long-term government interest rate series used here is an update of the series I

spliced together for my book Irrational Exuberance (Shiller, 2005), from Sydney Homer¡¯s

A History of Interest Rates (for 1871 to 1952) and the ten-year Treasury bond series from

the Federal Reserve (from 1953 on).

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Figure 1. Nominal Long-Term Bond Yields in Selected Countries, 1950¨C2007a

Percent a year

16

14

12

Euro area

10

8

United Kingdom

6

4

India

2

United States

1955

1965

Japan

1975

1985

1995

2005

Source: Global Financial Data.

a. Data are monthly and refer to yields on government securities of approximately ten years¡¯ maturity.

Certainly one can say that the world is still in a period of low long-term rates

relative to much of the last half century.4

Economic theory has widely been interpreted as implying that the discount

rate used to capitalize today¡¯s dividends or today¡¯s rents into today¡¯s asset

prices should be the real, not the nominal, interest rate, because dividends

and rents can be broadly expected to grow at the rate of inflation. However,

as Franco Modigliani and Richard Cohn argued nearly thirty years ago,5 it

may be, because of a popular model related to money illusion, the nominal

rate that is used in the market to convert today¡¯s dividend into a price.

The downtrend in nominal rates since the early 1980s is certainly tied

up with a downtrend in inflation rates over much of the world since the

4. Long-term rates are not any lower now than they were in the 1950s, but the high rates

of the middle part of the period are gone. In the United States, long-term rates are actually

above their 1871¨C2007 historical average of 4.72 percent a year. The best one can say from

this very long term perspective is that U.S. long-term rates are not especially high now.

5. Modigliani and Cohn (1979). The authors also stressed that reported corporate earnings need to be corrected for the inflation-induced depreciation of their nominal liabilities,

and investors do not make these corrections properly.

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Figure 2. Ex Post Real Long-Term Bond Yields in Selected Countries, 1950¨C2007a

Percent a year

12

10

8

6

4

Euro area

India

2

0

¨C2

Japan

United

States

¨C4

United Kingdom

¨C6

1955

1965

1975

1985

1995

2005

Source: Author¡¯s calculations using data from Global Financial Data.

a. Data are monthly and refer to yields on government securities of approximately ten years¡¯ maturity.

early 1980s. Figure 2 shows real ex post long-term interest rates on bonds

with a ten-year maturity in the same countries depicted in figure 1. The

annual inflation rate that actually transpired over the subsequent ten years

has been used to correct the nominal yield. (For dates since 1997, the entire

ten-year subsequent inflation is not yet known, and so the missing future

inflation rates have been replaced with the historical average for the last ten

years.) Note that there has been a strong downtrend in ex post real interest

rates over the period since the early 1980s as well. Indeed, this trend is

nearly as striking as that for nominal rates. Ex post real long-term rates in

some countries were remarkably close to zero in 2003. And just as with

nominal rates, real rates have picked up since then.6

6. The ex post real annual yield on U.S. long-term government bonds has averaged

2.40 percent over 1871¨C1997, which is below their yield in 1997 (the last year this yield can

be computed without making assumptions about the future). Even today, using the latest

inflation rate as a forecast, U.S. real long-term interest rates are not obviously low compared

with this long-run average. The best one can say for the popular view that long-term interest

rates are low today is that they remain relatively low compared with twenty or thirty years ago.

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Figure 3. Yield on Ten-Year Inflation-Indexed Bonds in the United States, the

United Kingdom, Australia, Chile, and France, 1985¨C2007a

Percent a year

9

Chile

8

7

Australia

6

5

United

States

4

3

United Kingdom

2

1

France

1985

1990

1995

2000

2005

Source: Global Financial Data.

a. Data are monthly, beginning in January 1985 for the United Kingdom, July 1985 for Australia, April 1992 for Chile, January

1997 for the United States, and September 1997 for Sweden, and ending in July 2007 for all.

However, ex post real interest rates may not correspond to ex ante, or

expected, rates. It seems unlikely that investors expected the negative real

long-term rates that, in the 1970s, afflicted every major country except stableinflation Germany. It is equally unlikely that they expected the high real

long-term rates of the 1980s. After the very high inflation of the 1970s and

the beginning of the 1980s, inflation in the United States and elsewhere came

crashing down. It may be that people did not believe that inflation could

come down so quickly and stay down over the life of these long-term bonds.

Market real interest rates, that is, inflation-indexed bond yields (shown

in figure 3), have a shorter history in the major countries than do ex post real

rates. In the United Kingdom, where available data on inflation-indexed

bonds begin in 1985, market real rates showed no distinct downtrend

between 1985 and 1997, the period when most of the decline in nominal

interest rates occurred. However, they do show a downtrend from 1997 to

2006. In the United States market real interest rates are unavailable over

most of the period since 1980 over which long-term interest rates have

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