Tags: interest | rates

Higher Rates Likely Even Without Inflation

By Michael Carr   |   Wednesday, 30 Sep 2009 10:11 AM

The Fed has declared the recession is over, but no one seems to be claiming that we are returning to robust economic growth.

In addition, there are many signs that the recovery will be jobless, which should keep wage growth down and inflation low.

Historically, post-recession inflation has been due to rising wages. At first, employees start working more hours which increases their take home pay. The increased spending inevitably leads to inflation, and that becomes an argument for increased pay.

In real-time, the bond market reacts by driving interest rates higher and the Fed follows by increasing official rates.

But, this time may be different. There are nearly 15 million people unemployed. Another million have left the work force because they gave up looking for a job. Nine million Americans are working part-time. This massive pool of potential workers is likely to allow employers to hire as demand increases without needing to raise wages.

While some, such as the Fed, would argue that means inflation will be subdued for years to come, that doesn’t mean interest rates will stay low. Even without inflation, higher interest rates are still very likely.

Interest rates reflect the cost of a bond, and the cost of anything is determined by supply and demand. If supply increases, prices are bound to fall. Since the prices of bonds are inversely related to interest rates, then if the government issues more bonds, their price will fall and rates will rise. That’s just basic economics at work.

If next year’s budget deficit comes in on target at $1.5 trillion, the supply of Treasury bonds will need to increase by $125 billion a month to finance it. It is very likely investors will want a lower price to absorb that much of an increase.

That factor alone, the ballooning supply of Treasuries, should lead to higher interest rates even without inflation. If inflation returns, then rates will go up even more, potentially derailing an already fragile recovery.

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The Fed has declared the recession is over, but no one seems to be claiming that we are returning to robust economic growth. In addition, there are many signs that the recovery will be jobless, which should keep wage growth down and inflation low.Historically,...
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2009-11-30
 

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