Why the fall over much of the last year and its recent return to the levels of one year ago (although still low in terms of the last 30 years or so)?  I approach the analysis of interest rates in a rather unique fashion.  I isolate the pure interest rate, from the market rates you see.  The market rates of interest you observe are impacted by changes in the price level (Fisher Effect) and differences in credit risk and tax treatment.  As I mentioned earlier, I have included in the hard copy form of my presentation, 4 chapters on interest rates from my text, Financial Economics.

 

Pure Interest Rate

 

Ø    If there were no changes in the price level and no expectations of any such changes.

Ø    If there was no credit risk, that is perfect certainty.

Ø    If the tax code was perfectly neutral.

Ø    There would be one and only one interest rate on all obligations and that rate, the pure interest rate, would be between one and two percent. 

 

What you see in the real world of financial markets are tens of thousands of interest rates reflecting varying price level change expectations, varying degrees of credit risk, the distorting affects of the tax code, etc.

 

My discussion will center primarily on the pure interest rate determined by supply and demand for credit and the expectations of changes in the price level.  These are powerful tools in analyzing overall interest rate movements. 

 

Let us use the 10-year U.S. Government bond rate.  This has replaced its 30-year counterpart as the benchmark rate because of the Treasury Department’s decision to retire the long-term end of the Federal Debt.  I disagree with this decision and last year I explained to you my view that it will make interest risk management less efficient and hence more expensive to holders of long term debt such as insurance companies and pension funds.  As usual, they ignored me.

 

The factors of supply and demand that determine the pure interest rate are such things as:

 

¨      The savings rate

¨      Increases in the quantity and velocity of M-1 or medium of exchange money.

¨      The amount of net foreign lending to the U. S. as measured by our current account balance.

¨      The deficit or surplus in the federal, state and local government budgets.
 

¨      The demand for capital goods. 

 

Some of these are offsetting.  Changes in these factors occur all the time and many of them are offsetting.  You might get another 100 basis point increase in the 10-year government bond rate, though I would not bet on it.

 

You have already had about a 125 basis point rise in the last few months from its low near 3%.  Absent any surge in inflation, I would not expect any further appreciable rise much beyond 5 percent in this rate.  A good deal of new corporate debt issues has already occurred to take advantage of the low market rates.   Much of the refinancing of the housing stock has already occurred.   Given the difficulty of reducing the unemployment, which is primarily due to restructuring and hard to reduce, the Fed will probably prevent, if needed, any significant rise in interest rates.

 

Over the past several years, I have tried to explain that the landscape of the American economy had gradually undergone a major change since the Second World War.  Increasing competition had gradually reached the point where firms, as certainly experienced in the auto industry had lost the control of price in a significant portion of this economy. 

 

The high interest rates that began in the later 1960s and exploded in the 1970s were due to the accelerating inflation of that period.  At an annualized rate, the CPI was near 20 percent in late 1979.  30 year fixed rate mortgages rate flirted with 20%.   But with an inflation rate averaging near 15% for the year, the real or inflation adjusted 30 year mortgage rate was around 5%, where it is now. 

 

Inflation is pretty much dead as a dodo bird.  Price power only appears where government has allowed monopoly power to exist or re-occur.  Professional sports, the oil industry, and tariffs on imported steel are a few of the examples.  Price increases are non-existent in autos, computers, etc.  As inflationary bias disappears, episodes of inflation become less frequent and declining in severity.  In fact, the probability of deflation occurring is increasing.

 

The major cause of large swings in interest rates is due to price level changes and not supply and demand factors.  This is unlike the pure interest rate fluctuations reflecting federal deficits and debt, or a flight back to equity, as has been seen in the stock market for the last several months.  Another hundred basis point rise in the ten-year government bond rate from such factors is possible but not highly probable.  But the likelihood of a significant inflation premium being tacked on to market rates of interest, as we saw throughout the 1970s, is close to zero. 

 

You have to understand that the possibility of a return of significant inflation is near zero.  Regulators are still concerned with the last disaster of the roaring inflation of the 1970s.  That is typical of regulators.  Back then, variable interest rates were the rare exception.  Securitization had just started to become popular.  If serious inflation should return (about as likely as hell freezing over), we have the tools to control damage from interest rate risk.  Shocking balance sheets by a 300 basis point increases may be required by regulators, but in the long run, they are about as useful as the thousands of bunkers and berms Saddam had in place during the First Gulf War.  You also have in place higher capital ratios to absorb the damage should interest rates rise appreciably, but that presupposes significant rises in interest rates which presupposes significant rises in inflation rates.

 

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