US Policy, Idaho, Onion Dip, and Rising Interest Rates

The news today was full of stories about rising interest rates. Rates are said to be rising because of a growing economy. The impacts of interest rates are one of the most complicated and misunderstood aspects of macroeconomics. Consider the popular discussions about interest rates over the last several years:

·         Interest rates rose before the onset of the current recession – that was bad.

·         Interest rates fell as the recession took hold. That too was bad.

·         The Fed instigated a policy to reduce interest rates further and that was good.

·         Interest rates are rising now and that is bad.

You might be saying – how can all that be true? It is possible only if you understand a little about cause and effect.  Here comes some macrofun! First, interest rates are fundamentally driven by changes in the demand and supply of credit. Whenever the demand for credit (borrowing) outstrips the supply (saving), interest rates rise as borrowers compete in a market that has an insufficient amount of saving available for their needs. The borrowers include households, firms, and the government.

Second, interest rates reflect the impacts of inflationary expectations and risk. If inflationary expectations rise or if financial risk rises – the savers demand a higher interest rate to compensate them for reductions in buying power associated with higher expected inflation and increased risk.

Third, while the above factors cause changes in interest rates, interest rates cause changes in the economy. Economists might use words like – “once interest rates change they create impacts in other markets for goods, services, equities, foreign exchange, etc”. So a full discussion of the impact of interest rates would include all the following:

·                X changes and impacts credit demand and/or supply

·                 Interest rates change

·                  Interest rate changes cause changes in spending, exchange rates, output, employment, etc

With this information and $3 you can get a coffee at Starbucks. You can also see why it is difficult to characterize and forecast interest rate issues. For example, interest rates were rising before the recession largely because spending in the economy was so strong that it created huge demands for credit. That might be considered a good thing because along with the higher interest rates was a very low unemployment rate. We like low unemployment, right? But wait, interest rates were also high because inflation and expectations of inflation were rising and the risk of a financial bubble were increasing. So the Fed decided to tighten the money supply and slow things down a bit. To do so the Fed drained money from the economy by selling government bonds. That added to the demand for credit even further and raised interest rates. The result was a clear realization by us all that housing and stock prices had peaked which quickly created a whole host of negative impacts on both Wall Street and Main Street. THE FED POLICY WORKED in the sense that it stopped the problem of rising spending. Of course, it worked too well since the unintended impacts on a very leveraged and interconnected global financial sector was a financial and real crash. Summary – rising interest rates were a sign of an economy growing too strong and they were bad because they led to a deep and long recession as well as a very weak recovery after the recession.  Whew—all that makes me hungry. Reward yourself with a trip to the refrigerator.

The above sequence of events led to very low interest rates – a mirror image of what came before – falling and low interest rates as a consequence of very weak aggregate demand, lower inflationary expectations, and a Fed that was buying bonds faster than a fox can eat lunch in a Kentucky Fried Chicken Store. Low interest rates were bad because they were associated with insufficient borrowing, weak demand, and the resulting very high unemployment rate. The lower rates were thought to be good because the Fed’s policy appeared to be necessary to resuscitate spending and the economy.

So let’s jump to today’s headlines which announce higher interest rates. Is that good or bad? You might be guessing from the above logic (optimistically assuming that you are still awake) that the answer is yes AND no. And you would be correct. Today’s higher interest rates are the direct result of a stronger economy and rising demands for credit. That’s good. Of course, today’s higher rates are also the consequence of rising inflationary expectations. That’s good news too if you worry that inflation is too low. Of course, if you look at any chart of inflation rates over the last 50 years you will notice that inflation has a tendency to rise beyond its goal value once it gets started moving upward. It isn’t the kind of thing that you can easily manipulate. It is a bit like that potato chip thing. Once you eat one salty, crispy chip with onion dip there goes Idaho.  So rising inflation is considered by some of us to be a problem. Not because we love Idaho but because without better policy we might be back where we were before the latest calamity hit.

Could today’s small interest rate rise really warrant all this concern? After all, Mr. Bernanke says that inflation is below target and we have lots of economic slack and high unemployment.  Bernanke might say – let’s wait until we see that we are clearly growing too fast. But that’s exact the issue. First there is the Idaho thing. 

Second, we have an unprecedented amount of liquidity just waiting to be spent thanks to the Fed’s policies the last years. Third, our government has an unprecedented amount of fiscal stimulus interacting with rising private demands. The firecracker might be wet and hard to light how. But watch out when the sun comes out.

It reminds me of the joke about the guy who falls off the top of a very tall building and as he is flying by the 10^th floor on his way down to the street a person sticks his head out of a window and asks “how are things going?” The guy responds that “things are fine so far.”  Well things are going fine right now as interest rates begin rising. I just hope Mr. Bernanke and our federal government don’t wait until too late to reverse engines. If not for America than please think about the potatoes in Idaho.