Interest Rates and the Murky Way Forward

CANUSEconOne of the beautiful things about economics is it is such a moving target.  Everything is fluid, every economic variable seems to change almost all the time.  Interestingly enough, what comes along on some unexpected Tuesday can sometimes change everything.  However, at the end of the day interest rates, fiscal policy and the value of the Canadian dollar get discussed every day.   Looking for that economic silver bullet that would give us some type of consistency to plan for it is every economist’s dream.

Through the years I like to think that I’ve seen almost everything.  For instance, I often tell audiences where I’m invited to speak that the first loan I ever got from a bank was at 23.25%.  That was way back in 1981 when interest rates skyrocketed and remained there for several months.  The effect those high rates had was a beating down on inflation and economic activity.  As odd as that might sound now in our recessionary times of 2010, that was the order of the day in 1981.

Since that time we have been on an ever-declining path for Canadian interest rates.  For most of us who have been here over the past 30 years it’s been constantly easier to borrow money.  In fact at the present time we have the cheapest interest rates in Canadian history.  It’s completely obvious interest rates are going up for the simple fact that they cannot go down anymore.  If they did we would be giving money away for free and that doesn’t make any sense.  Of course the question is when and by how much and are double-digit interest rates coming.

We got our answer last week and it was fairly telling.  The US Federal Reserve raised interest rates from .25% to .75%.  Effectively we are still close to zero, but that was enough to send the US dollar up.  Our American friends have been struggling to find the balance between lowering interest rates to boost aggregate demand and employment.  That is one reason that interest rates are so low.  Of course they have borrowed billions of dollars on that side of the border to support their economy raising the federal debt to huge levels.  This has effectively produced a “debt bomb,” which our American friends will need to finance.  Having the Federal Reserve raise interest rates makes it easier to attract foreign capital to finance much of that debt.  The question is does the Federal Reserve move last week give us any clues to future economic reality?

To me that is a very difficult question to answer based on my experience.  For instance everything in my economic bones tells me that with the US government borrowing so much capital, they will eventually pay it back by monetizing the debt.  In other words the US money supply will increase and we will have high inflation.  Eventually this will be countered with higher interest rates.  It’s all a balance.  The difficult part for me is truly deciding whether our economic reality is like that.  In other words based on the times where we are in now, will the US government monetize the debt?  Will there be the classic inflation, interest rate scenario play out that we have become very used to?  Or do the economic problems we have now featuring such unique variables that all bets are off going forward?  Of course we need to add the question, is there a danger of falling back into recession, even after the huge government stimulus?

The simple answer for me to these questions is “I dunno”.  The reason that I am questioning some of the economic benchmarks that I have learned over a period of years have to do with the Chinese holding all that US debt.  It also has to do with the growth in Asian economies versus the stagnant growth in the US economy and negative growth in Europe.  I simply don’t know how and when the current debt levels of government will be dealt with.

Having said that, there was a bit of a clue last week with the interest rate increase.  If I were to bet, I’d say we’d be back to over 10% interest rates by late 2012.  If that is to happen I am sure that we will look back at this past week when the Federal Reserve made its move. More clues will surely be in the works.  However, remember, its fluid, this time around, I don’t think there will be steady hand on the tiller.