When Interest Rates Rise
30 March 2013
CAMBRIDGE – Long-term interest rates are now unsustainably low, implying bubbles in the prices of bonds and other securities. When interest rates rise, as they surely will, the bubbles will burst, the prices of those securities will fall, and anyone holding them will be hurt. To the extent that Banks and other highly leveraged financial institutions hold them, the bursting bubbles could cause bankruptcies and financial-market breakdown.
Assume that the interest rate on ten-year bonds remains unchanged for the next five years and then rises from 2% to 5%. During those five years, the investor earns an additional 2% each year, for a cumulative gain of 10%. But when the interest rate on a ten-year bond rises to 5%, the bond’s price falls from $100 to $69. The investor loses $31 on the price of the bond, or three times more than he had gained in higher interest payments.
Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.