Cause and Effect and Interest Rates

As humans, we struggle with cause and effect, and it is understandable that President Trump does too.

I yelled at a student one day as I was driving on campus and almost hit him crossing in front of me. Clearly, he almost caused an accident. He chased me down and yelled at me for driving too fast. He told me that I almost caused the accident. Hmmm. Was he the cause and I the effect? Or was it just the opposite? With no police officer or bystanders around to adjudicate, I guess I will never know.

Monetary policy is even murkier as it relates to cause and effect. You may have heard that the Fed has decided to normalize interest rates in the USA. After keeping rates near zero for many years, the Fed has been using its levers to raise something called the Federal Funds Rate (FFR). It is believed that when the FFR rises, it pushes or pulls lots of other rates up. Thus, one might believe that when the Fed raises the FFR, it causes increases in interest rates on cars, houses, business loans, and so on.

It is also true that any of those interest rates can rise without any actions of the Fed. That is because interest rates are market variables. If people decide they want more chili dogs and fewer cheeseburgers, this can drive the price of hot dogs up and cheeseburgers down. We call that a market phenomenon. Similar forces are at play with respect to loans and interest rates. If the economy strengthens, more people want to use loans to buy houses and cars. Companies often want to borrow more so they can expand their businesses to meet the demands of a stronger economy. A rising economy, therefore, tends to raises interest rates on all sorts of loans.

With respect to cause and effect, we have learned two things. Thing 1 – the Fed can impact interest rates. Thing 2 – the economy can affect interest rates.

There is a Thing 3 worth mentioning. You alert folks might have noticed that the government has decided that it should borrow more because it spends more than it takes in taxes. I wrote about that recently. As of this year the government needs to borrow around $800 billion just to cover its deficit in 2018. That annual amount is heading toward $1 trillion per year. The government will be floating a bunch of treasury bonds to borrow all that money.

I could go on with other things affecting interest rates in the USA – putting pressure on them to rise. But most of us can’t balance three things in our increasingly senile brains, so let’s stop there. The point is that the Fed is only one of the three. Even if the Fed stopped its current policy of interest rate normalcy, these other factors would keep driving interest rates upward.

So what should we do? In one sense of cause and effect, rising interest rates are bad because they make buying cars, houses, and other things more expensive. But notice with Thing 2 that one cause of rising interest rates is a strong economy. Interest rates rising are the effect and not the cause. Clearly, we don’t want to have a policy to weaken the economy to bring interest rates down. So let them rise.

If interest rates are rising because of government debt, then that’s a different story. We can and should try to reduce interest rates in this case for two reasons. First, the cause is not a strong economy. Second, government deficits and debt are very worrisome risk factors on their own. Thus we can kill two birds with one stone. Reduce government debt, and this will reduce the risks of high government debt and reduce interest rates.

Forget the Fed. They are not the cause of much of anything as they try to restore normalcy. Let the economy grow at a reasonable rate, and let’s manage our government debt. If we do all that, we will likely forget interest rates and enjoy a better economy.