interest rates, inflation and economic growth

A reader asked me to write about this.  I think it’s an interesting topic, since traditional relationships appear to be be breaking down.

interest rates

Let’s just focus on government debt, since other debt markets tend to key off what happens here.


At the end of the term of a loan, lenders expect the safe return of their principal plus compensation for having made it.  In the case of all but gigantic mutual fund/ETF lenders, participants in government bonds also enjoy a highly liquid secondary market where they can sell their holdings.

The compensation a lender receives is normally broken out into:  protection against inflation + a possible real return.

In the case of T-bills, that is, loans to the government lasting one year or less, the total return in normal times would be: protection against inflation + an annual real return of, say, 0.5%.  In a world where inflation was at the Fed target of 2%, that would mean one-year T-bills would be sold at par and yield 2.5%.

In the case of a 10-year T-bond, the annual return would be inflation + a real return of around 3% per year, the latter as compensation for the lender tying up his money for ten years.  In a normal world, that would be 2% + 3% = a 5% annual interest rate for a bond sold at par.

Compare those figures with today’s one-year T-bill yield of 0.6% and 1.62% for the ten-year and we can see we’re not in anything near normal times.  We haven’t been for almost a decade.

How did this happen?

Fed policy

The highest-level economic objective of the government in Washington is to achieve maximum sustainable long-term economic growth for the country. Policymakers think that growth rate is about 2.0% real per annum.  Assuming inflation at 2.0%, this would imply nominal growth at 4.0% yearly.

expanding too fast

In theory, if the economy is running at a nominal rate much faster than 4% for an extended period, companies will reach a point where they’re ramping up operations even when there are no more unemployed workers.  So they’ll staff up by poaching workers from each other by offering higher wages.  But since there are no net new workers, all that will happen is that wages–and selling prices–will go up a lot.  They’re be no greater amount of output, only an acceleration in inflation.  This last happened in the US in the late 1970s.

Before things get to this state, the Federal government will act–either by lowering spending, raising taxes or raising interest rates–to slow the economy back down to the 2% real growth level.  Typically, the economy ends up contracting mildly while this is going on.

Given long-standing dysfunction in Congress, the first two of these remedies are long since off the table.  This leaves money policy–raising interest rates–as the only weapon in the government arsenal.

growing too slowly/external shock

If the economy slows too much or if it suffers a sharp out-of-the-blue economic shock, the possible government remedies are: lower taxes, increase spending, reduce interest rates.  Washington has elected to do neither of the first two in response to the financial collapse in 2008-09, leaving monetary policy to do all the work of helping the country recover.

Fed policy in cases like this is to reduce the cost of debt to below the rate of inflation.  That hurts lenders (the wealthy, pension funds, retirees) severely, since they are no longer able to earn a real return or even preserve the purchasing power of their money through buyng government securities.

On the other hand, this is like Christmas come early for borrowers.  In theory, they now have many more viable projects they can launch.  They’ll not only be making money on the merits of their new products/services; inflation will also be eroding the real value of the loans they will eventually have to pay back.


More on Monday.



Stephen King on productivity and monetary policy

The Stephen King I’m writing about is an economic advisor to HSBC who was formerly the bank’s chief economist.  He’s one of the most interesting economists I’m aware of.  For instance, he was one of the first to warn of excesses in the US housing market a decade ago, and perhaps the most vocal in doing so.

Last week he weighed in on the issue of productivity in an Opinion article in the Financial Times.  His main points:

1. The current low level of productivity–+1% yearly in the US, flat to down elsewhere–may not be due to lack of infrastructure spending (Lawrence Summers) or that most productivity-enhancing inventions have already been made (Robert Gordon).  It may be instead that we’re seeing now is normal.  It’s the generation that rebuilt after WWII, creating high growth in productivity in the process, that’s the outlier.

2.  If #1 is true, then many of the mainstays of orthodox macroeconomic policy need to be reexamined.  In particular,

–if the world is being flooded with money, then capital is equally available at cheap prices to high productivity enterprises and low ones.  The result may be that the very process thought to be increasing economic growth is neutralizing the competitive advantage of high-productivity enterprises

–in a low-inflation, low-productivity world, interest rates will be “dragged down to incredibly low levels,” meaning recession-fighting monetary expansion may be difficult to achieve

–cultural expectations built over the past half century of ever increasing prosperity may prove to be too high.  This would be trouble for, say, pension or social security schemes around the world whose ability to deliver promised benefits assumes the robust real economic growth of the past can be extrapolated into the future.

3.  The ability of governments to create inflation may become increasingly important, as a means of keeping nominal GDP growth above zero during an economic downturn.  Monetary theorists around the globe have assumed that doing so involves only the simple expedient of increasing the money supply.  The past eight years in the US, however, have shown that creating inflation is much easier to theorize about than to do.


His overall conclusion:  the Lawrence Summers idea of secular stagnation–which can be addressed through increased infrastructure spending–is a much cheerier outlook than it appears at first blush.

Baby Boomers: wounded by the Great Recession

Yesterday I wrote about Tyler Cowen’s semi-apocalyptic vision (if semi-apocalyptic is possible) of the US in the upcoming years.  His bottom line is that a small minority of tech-savvy Millennials will prosper while everyone else stagnates, distracting themselves all the while with their smartphones and video games.

A bit over the top?   …probably.  But maybe I should be nicer to my children, just in case.

There is, however, a much more straightforward way in which the economic environment since 2008 has been damaging to the Baby Boom and beneficial to Generation X and to Millennials.

It’s monetary policy.

When times are good, savers/lenders get a positive real return on their money.  That is, they receive interest income that compensates them for the effects of inflation + an extra percentage point to three or more, depending on how long the loan is or how creditworthy the borrower is.  When times are bad, the central bank steps in and pushes interest rates down below the rate of inflation to encourage borrowing and spending.  So returns on loans shrink, both in real and nominal terms.

Put another way, the central bank stimulates economic activity by taking money out of the hands of people who are loathe to consume and putting in into the hands of ardent spenders.  Senior citizens and the wealthy get dinged; the young and the willing-to-become-indebted have a field day.

That’s just the way macroeconomics works.  The elderly suffer for the greater good of the overall economy.

Three things are unusual–and unusually damaging to the Baby Boom generation–about the Great Recession:

1.  the biggest is the length of time fixed income yields have been depressed.  In a garden variety recession, the pain lasts a year or so.  But we’re now in year five of depressed interest interest rates, with the prospect of normal returns not reappearing until 2018.  Ouch!!!   That’s a decade of the old subsidizing the young.

2.  there’s also the amount by which yields have been depressed.  On the 10-year bond, it’s 300 basis points; on the 2-year note, it’s 350+bp.

3.  finally, there’s the fact that short-term rates have been reduced to zero.

Yes, arguably a real return of negative 2% is a real return of negative 2% whether the nominal return achieved is 3% (meaning inflation is 5%) or zero.  But there’s at least a sharp psychological difference between getting a monthly check for $2500 and one for $20.  And I’m not sure how people generally feel or behave when they’ve got to sell assets to meet living expenses–whether people can mitigate the negative effect on well-being by making substitutions.   Certainly you can’t substitute your way into making $20 go as far as $2500.

My point?

The money policy consequences of the Great Recession are just one more factor hastening the changing of the guard, in economic and stock market terms, away from the Baby Boom, and toward younger consumers.