December 17, 2010
There has been much hand-wringing in the business press lately about the recent rise in interest rates. The fear is often expressed that this will choke off the economic recovery and decimate further the still-weak housing industry. But in fact, rising interest rates are an extremely bullish sign; tangible evidence that the economy may have finally turned the corner and is poised for a sharp rise in growth.
The rise in rates has been greatest in the middle of the maturity schedule. Over the last month, for example, the yield on the Treasury’s five-year note has doubled from 1.04 percent to 2.08 percent. A month ago one could get a 30-year fixed rate mortgage at a rate of 4.17 percent; now it’s up to 4.83 percent. Short rates, however remain flat; the 3-month Treasury bill rate has been stuck at about 15 basis points (0.15 percent) since earlier this year.
To understand why this is good news, one needs to know something about the fundamental nature of interest rates. The most important thing is that economists talk primarily about the “real” interest rate. This is the rate that would exist in the absence of inflation. It is determined by many things, but primarily by the rate of return on capital. If businesses perceive a rise in profit-making opportunities and believe they can make more than the appropriate interest rate, they will borrow to take advantage of those opportunities.
Thus the main reason for low interest rates is the lack of profit-making opportunities by businesses that would justify borrowing to expand, buy new equipment and increase output. For the last three years, businesses have had no trouble meeting demand from their existing facilities and labor force. The capacity utilization rate in manufacturing remains 10 percent below what it was in 2007 and almost 30 percent below its theoretical limit. (In practice, manufacturing plants never get anywhere close to producing at 100 percent of capacity.)
Of course, the real interest rate is also determined by the supply of saving. Because people are fearful about the future, they have increased their saving significantly. The personal saving rate has risen from 1.4 percent in 2005 to almost 6 percent. Nonfinancial businesses, meanwhile, are sitting on $1.4 trillion of liquid assets that they could mobilize instantly for investments and job creation if they perceive a sustained rise in economic growth.
When thinking about saving, it is important to remember that borrowing is, in effect, negative saving. Paying off one’s debts is therefore the same thing as saving. Over the last three years, businesses and households have sharply reduced their borrowing, thus reducing negative saving. According to the Federal Reserve, households normally borrow over $1 trillion per year for mortgages, credit cards and so on. This year, there has been net negative borrowing of close to $300 billion, as consumers paid off credit cards and had debts discharged through bankruptcies and foreclosures. Businesses also borrow about $1 trillion per year. That sector had a negative borrowing rate last year, but this year it has been slowly picking up to almost $200 billion.
The federal government, on the other hand, has sharply increased its borrowing – like any debt, the federal budget deficit represents negative saving. But because of the sharp falloff in household and business demand for loans, it has not crowded private borrowers out of the market. In fact, total borrowing in the economy is 40 percent below what it was in 2007 even with a quintupling of the budget deficit.
Thus we see that the real interest rate is low because of an increase in the supply of saving and a decline in demand. But market interest rates are affected very importantly by expectations of inflation. Economists generally believe that if markets think that there has been a rise in expected inflation of, say, one percentage point over some future time period, then interest rates on securities with maturities over that time period will automatically rise by one percentage point. Lenders will demand more in order to get the same real rate of return and borrowers will be willing to pay because they can anticipate that their nominal rate of return will be higher as they are able to get higher prices on production and assets.
Inflation has been essentially flat for the last three years, thus reducing the inflation premium on interest rates. Consequently, real rates and market rates have been close to the same. And expectations of inflation also remain low based on market indicators such as prices on the Treasury’s inflation-protected securities. Since the real rate is guaranteed, changes in prices on such securities are a very accurate measure of market expectations of inflation.
Finally, there is the influence of the Federal Reserve. When it increases the money supply, the short-run effect is the same as if the rate of saving has risen. Since the impact of inflation is very low in the short run, the Fed can largely control short term interest rates. But insofar as a higher money supply leads markets to expect high inflation in the future, longer-term rates will rise because of inflationary expectations.
From this analysis we can see that the recent rise in interest rates is not necessarily a bad thing at all. To the extent that households have started to spend again, reducing their saving and increasing their borrowing, this will raise growth. To the extent that businesses perceive increased sales requiring an increase in output, this will lead to higher investment spending and the hiring of new workers. And to the extent that rates reflect rising inflationary expectations, this is also good up to a point, because it will encourage consumers to buy and increase business profits.
This is most evident in the housing market. While things like real estate prices, down payment requirements and bank lending standards are important to potential home buyers, the mortgage rate may be the most important because over the life of a 30-year mortgage people will pay far more in interest than principal.
Thus the rise in mortgage rates is very bullish for housing. Potential home buyers, who have been sitting on the sidelines for years waiting for the market to bottom before buying, have just been given a very powerful signal that the market has turned and now is the time to buy before prices and rates rise. While rising rates also make buying a home more expensive, rates would have to rise considerably from where they are before it starts to cut into sales.
Insofar as long rates are rising because of inflationary expectations, this is especially bullish. A key factor holding back bank lending for mortgages has been the fear that home prices would fall further, thus putting many mortgages “under water,” with outstanding balances greater than the value of the house, which often encourages borrowers to walk away and forces banks to foreclose. But a rise in inflation makes it much more likely that home prices will rise in the future, which will encourage banks to lend and people to borrow.
Many people will decry any rise of inflation and insist that the Federal Reserve begin tightening monetary policy immediately. But right now, the necessity of raising growth and reducing unemployment is vastly more important than maintaining close to zero inflation. Price stability is also important, of course, but worrying too much about it is like worrying about the water damage from fire hoses while one’s house is still on fire. In other words, first things first – put out the fire and get the economy growing again, then we can turn our attention to the water damage and inflation.
It’s important for people to realize that interest rates will have to rise quite a bit just to get back to “normal.” It’s hard to know how long this will take, but could take quite a while. The best thing that could be done to make sure that rates don’t eventually rise to a level that will choke off growth would be to put in place now a long-term deficit reduction plan so that federal borrowing will fall to accommodate higher consumer and business borrowing.
In conclusion, the hand-wringing over rising rates is overwrought. It’s important to remember that low interest rates are a sign of weakness because there is no reason to borrow in a slow economy. Rising rates are a sign that we may be returning to normalcy after three of the ugliest years in American economic history. It should be applauded, not condemned.