The Case for Low Rates
Inflation or deflation? Rising interest rates or falling? Pundits continue to make the case daily for both scenarios to develop, and the answers will no doubt impact asset prices the next few years. Five phenomena, however, tell us that the likely course for interest rates is to rise modestly, but to generally stay at historically low levels.
More Demand than Supply
It may seem counterintuitive that bond investors would crave U. S. Treasuries yielding 0.2 to 2.5 percent, but there’s no doubt that their continued appetite has helped push up bond prices and push rates back down in 2014. Exacerbating the decline in rates has been a steady improvement in the finances of the federal government, whose yearly deficits are one- half their recessionary peaks— hence, there is less supply of new Treasury bonds for yield- starved institutions to bid on.
Continued Slack in the Economy
The level of interest rates prevailing in an economy will, of course, correlate to the rate of inflation. Those looking for a surge of inflation from the recent flood of cheap money forget that even during the commodity boom from 2006 to 2007, when most raw material prices hit simultaneous peaks around the world, the consumer price index ( CPI) in the United States was rising at just 3 percent annual rates. It is unrealistic to expect 3- percent inflation today when commodity prices are far below 2007 peaks, wages are rising at just 1 percent annual rates, American industries still operate at just 78 to 79 percent of capacity, and several million workers remain jobless.
Beggar thy Neighbor Export Pressures
With the U. S., Japanese and Eurozone economies mired in subpar growth, central banks and policymakers have sought to grow their nations back to prosperity by emphasizing exports. Keeping currency values low relative to trading partners’ currencies has been a means to that end and has incentivized central bankers to keep rates low to discourage foreign investment. We frankly see this downward pressure on currencies continuing, as China, Brazil, South Korea and the European Central Bank all recently have sought to push down their currencies and in the process “export deflation” to their trading partners.
Low Turnover of Money
In classic economics, the size of the economy roughly equals the money supply multiplied by the turnover rate of money. Starting in 2008, the turnover rate ( velocity) plummeted and continued to plummet into 2013— long after the recovery began. Simply put, all the injections of stimulus since 2008 did little to bolster consumption and investment, but were used instead by businesses, banks and individuals to pay down debt and create large cash cushions. As long as this defensive behavior persists, economic growth will remain stalled.
Government Balance Sheets Need More Repairing
Finally, we can’t overlook the intense pressure policymakers in Washington are under to keep rates very low for the foreseeable future— whether that policy is the correct course or not. Allowing rates to rise could imperil rebounding, ratesensitive industries such as housing, autos and construction whose participants have levered their balance sheets to low- cost funds. More ominous, a rise in rates by just 1 to 2 percentage points would have huge impacts on government budgets by swelling interest costs on debt and crowding out spending on politically popular programs. Just as worrisome, rising rates would impair the face value of some $ 22 trillion of federal and municipal government bonds held on the balance sheets of institutions and banks around the world, causing huge mark- to- mark losses that could force these firms to contract their activities.