The Future for Interest Rates

While The Bernanke Files never "looks into its crystal ball" and speculates about the future, we would like to discuss what economics ripples might occur when the we exit the recession. More specifically, this entry examines the effects on interest rates.

Currently interest rates are very low. The Fed discount window is at .25%, and 10-Year Treasury Bonds yield 3.71%. This tells us several things, but probably the most important thing it tells us that investors are very wary of starting new ventures. Since the yield is 3.71%, we know that an investor believes he CANNOT MAKE MORE THAN 3.71% outside of buying T-Bonds. While in reality this is too simple (the low interest rate includes a very high premium for the extreme safety it offers), this is a good place to start.

When the economy begins to turn around, these same investors will want to be taking advantage of a strengthened economy. Unfortunately, their money will be tied up in the T-Bond they purchased for, lets say, 8 more years. They have two option: keep the low yielding bond, or they can sell the bond for cash. If the investor chooses the latter, supply of bonds will go up and the interest rate will go up also!! (Remember, if supply goes up, than price goes down and the interest rate goes up).

It is at this inflection point (the point at which almost everybody with a T-Bond realizes investing is better than holding a low interest rate bond) that we will have to worry about another slowdown in the market because INVESTMENT will be stifled by higher interest rates. In other words, there will be a small window that interest rates will move between (the window between a very low interest rate and an interest rate that stifles investment).

If Congress runs too much of a fiscal deficit and has to borrow too much money (thus selling bonds), the enormous dropping of T-Bonds into the markets will make interest rates rise out of the window pushing us back into a recession.

At this point, though, foreign countries that export goods (China, India, Germany), will see a drop in exports because the USA slips back into a recession. They will reduce their employees wages by taking profit and purchasing T-Bonds. This LOWERS the interest rate in America and, because their is so much cash going into America, credit becomes easy and a bubble is created.

Of course this is an oversimplified model, but it shows how complex of a job economists have. Remember, this is almost exactly what happened from the 2001 recession through to the 2008 recession. It is interesting that while most people blame the Federal Reserve for easy money, they are curiously and I believe rightfully absent from the model. Easy money came from Congress fiscal irresponsibility, not the Federal Reserve keeping the discount window interest rates too low for a couple of quarters.