Lesson 17 Interest Rates

Everyone knows what an interest rate is. But today the interest rate is more talked about than Howard Stern’s new personality. The Fed has a new policy to increase interest rates, yet interest rates go in the opposite direction. Is this a Putin plot to control the US economy? Maybe, but it is also true that most of us don’t know squat about interest rates, so let me waddle into the fray and try to make us all experts. I also explain why I think US rates will rise, and the prediction is not mainly the result of Fed policy.

There are more interest rates out there than new expensive bourbons. Dang, even Washington State is making bourbon. That should really infuriate our Kentucky friends. Interest rate is a phrase that means if you let someone have some of your money for a while, they will give it back with a little bonus. Consider my savings account at the local credit union. I gave them several thousand dollars, and I got 18 cents back in interest this month. Not all financial assets are that crappy thankfully, but in today’s financial scene, we talk about interest rates being very low. You can earn interest on savings accounts, short-term government bonds, long-term government bonds, private bonds, and so on. 

In macro, we talk about things like national output, the price level, the wage level, and so on, even though we know there are many different goods and types of labor. So it is with interest rates: we often refer to “the interest rate” even though we know there are many of them out there. So my first order as macro blogger-in-chief today is to say that the 10-year US government bond is often used as a statistical indicator of the US interest rate. Today that rate is at about 2.3%. To put that rate into perspective, it achieved a high in the early 1980s at 15% and as recently as 2007, it peaked at more than 5%. So it is pretty clear that at 2.3% interest rates are very low today. If you buy a bond for $100 then you would expect to receive roughly $2.30 in interest over the course of a year. That will not buy you one espresso mocha at Peet’s.

So why is the interest rate so low today? Why is the Fed having trouble raising it? And what explains the future course of interest rates? Wow – lots of questions.

Let’s address the various things that impact interest rates. If you lend money to a company, they are going to use it to improve the company. So if prospects are good for companies, they are very apt to be borrowing. Suppose a company borrows money to expand the capacity of one of its manufacturing plant. If prospects suggest a 5% return on money they borrow, then they don’t mind paying 3% to borrow the money. So a major factor affecting interest rates is optimism about the future economy. The more optimistic firms are, the more they are willing to pay for funds. The more pessimistic they are, the less they are willing to pay to borrow.

A second factor is inflation expectations. Paying back a loan takes time. The lender receives these payments and that constitutes their return. If the prices for goods and services rise during the payback period, the lender receives dollars that are worth less in terms of goods and service. Thus, at the beginning of the loan, it behooves the lender to anticipate future inflation. Imagine if they think inflation will reach 100%. A 4% interest rate would be lame. Maybe 104% would be better and would protect them from the expected inflation. So we say that today’s interest rates have an inflation premium. The higher expected inflation is, the higher is the interest rate.

What else affects the interest rate? A third factor is risk. Risk relates to the expectation of the lender receiving no payments. That is, if the economy tanks sometime in the future, then the lender gets nada. The riskier the economic environment is, the more the macro risk rises and the more lenders want today in the way of an interest rate.

That’s a long list of factors affecting the interest rate – optimism about business prospects, inflation expectations, and risk. What else? The general idea of supply and demand as it impacts bonds points to other factors like returns in the stock market, real estate, insurance policies, and foreign assets. One has choices in holding assets. Instead of owning bonds which give you a rate of return, you could also choose to have stocks, real estate, savings accounts, and similar assets from other countries. Thus, anything that makes these other assets relatively more attractive will reduce the demand for bonds and raise the interest rate. For example, if interest rates begin to rise in Europe, investors might sell US bonds so as to buy more European bonds. This would lead to a rise in the interest rate in the US.

Finally there is the Fed. Usually the Fed tries to impact short-term interest rates but quantitative easing suggests they attempt to influence the entire term structure of rates from short to long-term.

I probably have forgotten something but you can see the list of things that could impact the US interest rate is pretty long.

Anyone who wants to think about the interest rate today or in the future has to grapple with all these factors. What do you think about these?

US business confidence?

Inflation expectations?

Macroeconomic risk?

Stock market gains?

Relative desirability of real estate, life insurance products, banking products?

Interest rates abroad?

Fed policy ?

Price of JD?

Here is my quick outlook. As the distance from the great recession widens, the world economy is going to continue to slowly improve. Along with these improvements will come more optimistic assessments of US economic growth.

Worries over long-term changes in labor force participation and productivity will remain but will be lessened. As these worries recede aggregate demand will get even stronger and the result will be higher employment, wages, and inflation.

While I am not predicting a resumption of very high economic growth, I am projecting a more positive response than is now envisioned. With the Fed slightly more worried about inflation, their policies combined with the more sanguine macroeconomic outlook will produce a clear cycle of rising interest rates. Since the US will likely be leading this global parade, our higher interest rate will spill over to higher rates abroad and will create international impacts that will raise US rates even more. 

I hesitated about going further but no economist makes a prediction without covering his butt. Nations are prone to making horrible policy choices. It will take some doing but a general recognition that new policies will be inherently bad for economic growth could lock us into interest rate purgatory for a long time. The US, China, the EU, and several other places need to keep their collective foot on the growth pedal. Stupid stuff will keep it all low --  interest rates, economic growth, investment spending, productivity growth, and labor participation. Focus on the growth ball, guys. Plain and simple. Interest rates will go up and we will enjoy it.