Scott Sumner  

What are the implications of higher interest rates?

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The Mercatus Center has a new colloquium on the current low interest rate environment, and the implications of higher rates in the future. My contribution discusses four possible ways that interest rates might rise:

1. Tighter money
2. Easier money
3. Fiscal stimulus
4. Pro-growth (supply-side) policies

This is an area rife with "reasoning from a price change." If someone talks about the Fed "raising interest rates next week", then in context it's pretty clear that they have in mind the first option---higher rates via a tight money policy. But if they say that the Fed should move the US away from the low interest rate environment of the past 8 years, I have no idea what they are proposing. Would that be achieved via an easier money policy? Or a tighter money policy? I'd argue that an easier money policy is more likely to raise interest rates over the next decade, but in many cases people seem to have something else in mind.

The same is true of fiscal policy. There are two different ways that fiscal stimulus might push interest rates higher. A bigger budget deficit would require more federal borrowing. This would depress bond prices and raise bond yields. However the effect is likely to be quite modest, as the global credit markets are very large relative to the size of the US budget deficit.

Alternatively, a cut in marginal income tax rates (plus deregulation) might boost economic growth. This would increase the private sector's demand for credit, and push up interest rates. Unfortunately, much of the recent discussion has blurred these various factors together; making it hard to see which mechanism is being proposed.

The colloquium contains many other essays, by people like George Selgin, Arnold Kling, and Joe Gagnon.


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COMMENTS (5 to date)
Lorenzo from Oz writes:

Your Mercatus piece is beautifully clear. And reminding folk of the Australian example.

(Though we have just had a quarter of negative rGDP growth.)

Rajat writes:

Thinking of the AD-AS model, supply-side reform should boost economic growth but put downward pressure on prices/inflation. Does that mean real interest rates might rise, but nominal interest rates could remain steady (or even fall)? Most of the hand-wringing about the 'low interest rate environment' seems to be about low nominal rates. To get higher nominal rates, it would seem necessary to have looser monetary policy to boost AD and allow inflation to stay steady while AS is expanding. That would mean lower rates, at least initially.

Andrew_FL writes:

@Rajat-"Does that mean real interest rates might rise, but nominal interest rates could remain steady (or even fall)?"

Not if the Fed sticks to a particular targeted rate of inflation.

Ken From Ohio writes:

Great article. It has helped me understand the effects of Monetary and Fiscal Policy on interest rates.

I very much agree with the population growth / productivity growth concept of fiscal economic stimulus

I would add regulatory relief as a source of fiscal economic stimulus.

The promise of regulatory relief..I believe..is a source of the recent stock market increase. The PE ratios of the DOW and S&P are around 25. But the forward PE projections are only slightly higher at 18ish. So it seems the market is projecting higher future earnings.

Jonathan San Miguel writes:

There are several ideas that must be noted about the potential implications for high interest rates:

1. If the interest rate goes higher, it means that the Federal Government is increasing the amount of bonds being sold, thus lower prices and higher interest rates because they have an inverse relationship.

2. The government is tightening the selling of bonds and government securities, because the economy at this current time is potentially getting better and thus more prosperity is occurring.

3. People will have more incentive to save money and they will not be borrowing as much money as when lower interest rates was the intact policy.

4. The real rate of interest would not be affected that much because higher interest rates usually signals lower inflation, and because the Fed controls the "Real Rate" in the short run, there would be no drastic change after inflation is accounted for. Thus, AD would not increase by that much.

The Wall Street Journal has written that the Fed is expected to increase the interest rate from 0.5% to 0.75%! With the stock market the way it is going right now (WSJ says it is "buoyant") and with lowering unemployment, it will be very interesting to see what the Federal Reserve does over the next few days, with regards to interest rates.

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