October 29, 2003
In response to the e-mails of some of my readers, I again
will discuss the utterances of Treasury
Secretary John Snow. I also will
repeat some methodology I presented a few weeks ago.
But I think the exercise will be worthwhile.
The Secretary purportedly stated that he would be concerned
if interest rates did not begin rising soon.
In response to his comments, long term interest rates jumped, the dollar
rallied (higher yields make our currency more attractive), and stock values
The world was wrong in assuming that the Secretary was
preparing investors for a change in policy.
Mr. Snow was merely making a forecast based upon his sense that a growing
economy would push interest rates higher.
Of course, the facts tend to support the Secretary.
A "normal" business cycle experiences falling inflation and
interest rates into the beginning phase of recovery.
However, when the recovery begins to accelerate, that decline in price
changes and interest rates stalls and soon reverses direction.
However, nothing in economic theory suggests that the
"normal" pattern must happen.
As mentioned in an earlier column, lenders want to get back
the purchasing power they provide to borrowers. This means that they want enough interest to compensate for
the erosion in the purchasing power of the loan's principle over the time of the
Of course, no one knows what the inflation rate causing
that erosion will be. However,
lenders have expectations of inflation that must be met, or they will not give
up their purchasing power. (Lenders
probably also need to be compensated for the taxes paid on interest income, but
those taxes do not change often enough to be included in most discussions).
At the margin, lenders also will provide their resources to
the best paying opportunities. If a
lot of borrowers are competing for resources, interest rates could rise
When economic growth is balanced, this second factor in
interest rate determination will equal the additional value provided by a new
dollar invested in capital, what economists call the marginal product of
When overnight money is in equilibrium only the expected
rate of inflation and the marginal product of capital are in play.
(Because the economy is not in equilibrium, the Federal Reserve currently
is providing sufficient overnight money to push those rates well below
equilibrium. As economic growth
becomes sustainable, such "subsidy" of rates needs to end).
However, when lenders are asked to provide funds for a
longer period of time, a third factor enters.
Economic conditions change, and lenders may need to regain purchasing
power before the term of the loan is over.
They can do this by selling the debt instrument to someone else.
The price they receive for that sale will depend upon what
interest rates are at the time of sale relative to the terms of the debt
instrument. If rates have
increased, the debt must be sold at a discount.
The lender might also have the opportunity to take a profit if rates have
fallen. (The buyer will pay more
for a debt paying higher interest on its principle than the rates currently
being provided in newly issued debt instruments). This risk of fluctuating interest rates will lead to lenders
asking for a premium to hold longer term notes.
Thus, the three main determinants of interest rates are
inflationary expectations, competition for a lender's money (defaulting to the
inflation adjusted marginal product of capital in equilibrium),
and a premium for lenders of longer term debt instruments (depending upon
how uncertain a lender is about the direction of rates).
Now, how does a stronger economy impact any or all of these
factors? Stronger growth might
raise inflationary fears, but not if growth is caused by a higher sustainable
growth path because of productivity changes.
More people will compete for funds as an economy strengthens, but this
can be mitigated if the government is sharply lowering the deficit in an
expanding economy. Long term
interest rates might become more volatile, but only if economic growth is
missing its sustainable growth path (although it almost always does).
Historically, Secretary Snow is on solid ground in his claim that stronger growth means higher interest rates. However, economic theory says "it ain't necessarily so."