Friday, April 18, 2014

Five Reasons Interest Rates Aren’t Going Anywhere This Decade

Five weeks ago, I took a look at new Fed chair Janet Yellen.  I said that she cared more about jobs than about curbing inflation, which was a good thing, since American work opportunities have stayed scarce while annual price increases have been low since George H. W. Bush was president.  Still, we’re seeing some renewed inflation fears, leading to speculation that interest rates might be raised to prevent it.  Is that reasonably possible?  No, it isn’t, for five reasons.

First, on Wednesday we had some more words from Yellen.  When she addressed the Economic Club of New York, she mentioned full employment, saying that it was “for the first time since the crisis, in the medium-term outlooks of many forecasters,” but the end to chronic joblessness was projected “to be more than two years away.”  That means that she seems to believe the jobs crisis will end, and that it will take some time.  Combine those two ideas, and it seems she will wait for a large employment improvement.  That means staying the course, which as of yesterday was a 0.25% federal funds rate, a 0.75% federal discount rate, and the result of a 3.25% Wall Street Journal prime rate.  With other developed countries even lower – prime rates in Canada, Japan, and the Euro zone are now 3%, 1.475% and a rather stunning 0.25% respectively – if the jobs crisis is permanent, there will be little change.

Second, Yellen said, also Wednesday, that “as the labor market slack diminishes, it will exert less of a drag on inflation,” which she acknowledged had been under 2% for some time.  It has actually been 18 months since inflation worked out to more than 2% per year, and ten months before that since it was over 3%.  Although the official unemployment rate has dropped substantially over the past nine months, annual inflation for them, working backwards, has been 1.5%, 1.1%, 1.6%, 1.5%, 1.5%, 1.2%, 1.0%, 1.2%, and 1.5%.  Given that food and energy costs have fluctuated as usual since July, we couldn’t expect any more of a steady state, and it has been ten years since monthly inflation has had nine consecutive months in such a narrow range.  If the labor market, including its prodigious latent demand, stays loose, there is no reason to believe that further unemployment rate reductions will cause prices to jump, and interest rates will not significantly rise. 

Third, the federal government now owes about $17.58 trillion, mostly financed through the sale of bonds.  At 2% interest, debt servicing costs about $350 billion per year.  Triple that, to rates actually much lower than were in effect for decades, and we would pay over a trillion in interest, which would be more than defense costs, Social Security payouts, or Medicare and Medicaid combined.  Our public sector is addicted to low interest rates, and that is reason enough for extreme pressure to keep them that way.

Fourth, the jobs crisis keeps demand for goods and services low.  Inflation happens when willingness to buy products exceeds their supply, and, with so many people having minimal money to spend, the latter is healthier than the former.  As a result, business borrowing will remain lukewarm, allowing the supply of funds to stay ahead of it. 

Fifth, we have now gone more than four years without a recession.  There is no reason to think that will continue indefinitely.  The jobs crisis, making Americans feel as if they are in a cyclical downturn, does not mean the real thing won’t happen.

So there we are.  If you are called upon to place bets, through borrowing or investment decisions, do not be scared that it will suddenly be 1980 again, or even 2008.  A lot of things could happen during the rest of the decade.  Ukraine may fall completely under Russian influence, a cure or solid prevention for cancer may materialize, Google Glass devices could outnumber regular spectacles, and a Tea Partier could be elected president.  The Cubs could even win the World Series.  But one thing will stay the same through at least 2020 – American interest rates will remain low.

1 comment: