Bernanke on Why Rates Might Rise

One of the more common questions I get in the Ask Cullen section is “what if interest rates rise in the USA?”  Of course, that would have broad ramifications on the cost of US government debt, asset prices, the recovery, etc.   But you have to keep the sequence of events in order here and ask yourself first, “what will cause rates to rise”?   I think Ben Bernanke certainly knows what will cause rates to rise (per his testimony today):

“The economy will get stronger because of good policies, and that in turn will cause rates to rise in a sustainable way. If we were to raise rates prematurely we would kill the recovery and rates would come down, and we would have a long-term situation with very low rates.”

“The best way to get sustainable high returns to savers is to get the economy back to running on all cylinders. It’s somewhat paradoxical, but in some ways the best way to get interest rates up is to not raise them too quickly, because by keeping rates low, now, we can help the economies get stronger, we can create more jobs, we can create more momentum in the economy, that’s the way to get a sustainable higher set of interest rates.  Until we can get greater forward momentum, we are not going to get sustainable higher returns.”

“One of the paradoxes is that the best way to get interest rates up is to have low interest rates, because that promotes a stronger growing economy and that causes interest rates to rise. In some ways the fact that interest rates have gone up a bit, and it happens on the real not the inflation side, is actually indicative of a stronger economy, which again suggests that maybe this is having some benefit.”

Interest rates on US government debt are really a function of economic growth.  If the economy is weak the Fed will pin short rates to stimulate the economy.  As the monopoly supplier of reserves to the banking system the Fed can always set rates at the short end of the curve.  Long rates on government debt are largely an extension of short rates so there tends to be a very high correlation between the two.

So, the best way to think about rates is to think about the economy, how the Fed expects the economy to look in the coming years and then look at how traders might attempt to front-run the Fed’s policies.  But remember, the Fed can control the yield curve, but it can’t control the economy.  It can only nudge the economy by changing some influencing variables.   But ultimately, the path to higher rates lies with the economy.  And if rates rise it’s going to be a function of better days ahead.  So, don’t get too worked up over interest on the national debt or what will happen when interest rates rise because, by then, we’ll likely be talking about ways to cool down the economy….Which is a nice problem to have assuming we’re not cooling down the wrong areas (like asset bubbles caused by programs such as QE)….

-------------------------------------------------------------------------------------------------------------------

Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

More Posts - Website

Follow Me:
TwitterLinkedIn

Comments

  1. Tampering with interest rates and money printing doesnt make traditional relationships between growth and inflation valid.

  2. Very well said. A rise in interest rates will reflect a stronger economy. We should look forward to the day.

  3. What if we got a major sustained oil price shock? Couldn’t that cause cost push inflation and higher rates?

  4. Do you have a feel for the effect on demand of interest rates re savers versus borrowers. Low rates aren’t good for savers but are for borrowers, is it clear cut that lower rates stimulate because debt driven demand is more important?

  5. Bloomberg Business Week has an interesting article on the reported Real Estate market “recovery”. Supposedly, things are rapidly heating up again in major markets (Phoenix in particlular is highlited). I can’t help but, think this may be a bubble in the making again…with job growth, and wages remaining stagnent. The greatest contributing factor, I would think is the absurdly low cost of financing (again, the unintended/intended ? consequences of ZIRP).

  6. Dave, borrowers are required by the banks to create money (aka deposits). Savers are less important as banks create money out of thin air. Therefore, it would seem to me that the benefits of lower rates (in terms of the money creation process) have a much more powerful impact on the economy than the negative impact on savers.

    But I have seen other, more govt focused schools of thought, state that lower rates reduce the overall amount of income in the system. Also, to the extent that lower rates reduce the govt deficit, one could argue that they are anti-stimulative, all else equal.

  7. Here in the UK year after boring year we find people saying don’t buy property now rates will go up and bang you will lose. It never seems to occur to these people that ultimately rates will only go up because actually the economy is doing well and people are at last reaping the benefit in their incomes hence there will be no rate armageddon to answer to.

  8. Bernanke keeps selling the myth that the FED controls interest rates. And the FED doesn’t. The REAL “Mr. Market” does.

  9. If and when the economy starts humming and rates go back to the historical average, and we’ve got to finance the debt at 6 pct — can we really manage $1 trillion annually in interest payments?
    That would seem an impossible task, politically and economically. It would appear that we are going to be seeing permanantly low Treasury rates with the Fed trying its best to keep rates artificially low just to keep the interest payments from swamping us.

  10. “Interest rates on US government debt are really a function of economic growth.”

    Economic output RELATIVE TO potential output. Crucial addition.

  11. I’d like to see a chart that shows both interest rates and economic growth. I wonder if the correlation is that strong. We had very high rates in the late ’70s and early ’80s despite stagnant real growth.

  12. Do any of you REALLY BELIEVE that interest rates are going to rise in your lifetime?

    After spending trillions of dollars in stimulus over the last four years, economic growth is a little over 1% and unemployment at 8%.

    What is going to make interest rates rise?

  13. same thing over and over and over and over and over and over again. People have address your points, but you refuse to digest the information….

  14. you and johnny should start your own blog where you can copy and paste your responses over and over again.

  15. That question has never been addressed here.
    All we ever get is ‘Oh that won’t happen,’ or, ‘We’ll be growing so fast it won’t matter’ or ‘Savers will be happy!’ or ‘The Fed can always procure more money!’

  16. Interest rates on U.S. government debt are really a function of economic growth

    Under the influence of the Keynesian dogma, academicians have been trying for too long to analyze interest rates in terms of the supply of & demand for money. A “liquidity preference” curve is presumed to exist which represents the supply of money. In this system interest is the cost which must be paid, if lenders are to forgo the advantages of liquidity. All of this has little or nothing to do with the real world, a world in which interest is paid on checking accounts.

    Interest is the price of obtaining loan funds, not the price of money. The price of money is the inverse of the price level. If the price of goods & services rises, the “price” of money falls. Interest rates in any given market at any given time are the result of the interaction of all the forces operating through the supply of, & the demand for – loan-funds (not gDp).

    “The demand for money should not be confused with the demand for loan-funds. The demand for loan-funds is not a demand for money, per se, but a demand which reflects the advantages of spending borrowed money. Insofar as there is a relationship it may be said that an increase in the demand for loan-funds tends to be associated with a decrease in the demand for money”

  17. Can we afford it? The interest on govt debt is a cost of the US Tsy which adds to the deficit. We are paying 1T a year in the deficit now. So yes, we can afford to pay 1T in interest payments going forward. It might cause inflation at some point which would be expected in a very strong economic environment….

  18. So you’re assuming the budget deficit will go to zero?
    I don’t know of anybody who is projecting that.

  19. How will interest payments swamp us? You’ve been on this site long enough to understand there is no solvency constraint in Federal spending so can you please drop that meme. So economically, yes it is manageable.

    Politically, if the economy is improving and unemployment drops, our deficit will drop naturally through increase tax receipts and a decrease in unemployment and welfare expenditures. So I don’t think you will see the same uproar from the mainstream about the debt that is “killing us”. Plus, maybe a republican will be in the White House and Fox News might conveniently forget to put a camera on that debt clock in Manhattan. Sure there will always be people screaming about the debt, and TIME magazine might do a cover story about the country/SS/Medicare going broke like they’ve done every 5-10 years since 1965, but maybe, just maybe, all of this MR might finally sink in and we will be spared from responding to the same question from you.

    Or a nuclear disaster could strike the US, leading to severe droughts, a breakdown of law and order and we get hyperinflation. Then you can come on here and say I told you so, but I would suspect you would have more pressing issues to deal with at that time.

  20. So you really believe that if we were paying $1 trillion today in interest payments (rather than the $220b today) that it wouldn’t present problems?
    Your assumption is that the deficit will disappear when the economy improves, when almost every serious study shows that the structural issues are going to cause spending to rise over the coming years.

  21. Johnny, you know there isn’t really a default constraint, but there certainly is an inflation constraint. It the interest rate on the govt debt became high enough, leading to an accelerating deficit, it could indeed be a serious inflationary concern.

  22. I don’t think there is a default constraint. I understand the Fed can procure or buy all the bonds it can issue.
    Inflation is a constraint, but one that barely gets mention in here because we don’t see it now.
    There are other constraints, too, which don’t get much of a mention.

  23. Never did I say the deficit disappears, and then you incorrectly assume that spending increases automatically means deficit increases. Tax receipts could outpace spending increases, reducing the deficit and reducing the rate of issuance of new debt. How did the deficit shrink in the late 90’s? Did we suspend SS or put the army on ice for a few years? Or was a booming economy producing extremely high amounts tax receipts?

    And Cullen just pointed out that we are already paying $1 trillion in interest payments today, but I’ll bite. If we were paying $1 trillion instead of $220 bn, our deficit would be larger. The private sector as a whole would have more income. The private sector as a whole would spend more, businesses would ramp up production to satisfy the increase in demand and more people would become employed. The Fed would then say, hey unemployment doesn’t seem to be a problem, but inflation is starting to creep up, let’s raise rates. Meanwhile, the Treasury is starting to see an increase in tax receipts because of the increase in economic activity in the private sector, thereby reducing the rate at which new debt is issued and reducing the deficit. At this point, you might begin to realize that the economy is a whole lot more complicated and dependent on way more factors than just the level of the gov’t deficit and the federal funds rate.

    So what did I think? I’m holdin’ out for something better. I figure, fuck it, while I’m at it, why not just shoot my buddy, take his job and give it to his sworn enemy, hike up gas prices, bomb a village, club a baby seal, hit the hash pipe and join the National Guard? I could be elected president.

  24. What other constraints besides inflation don’t get mentioned here, that you have also omitted from mentioning?

  25. The deficit would be larger, and private sector will have more income and if the private sector spends that income, more people would be employed and inflation will be higher than it is today.

    Never did I say the deficit will disappear. It may certainly be reduced because of increased tax receipts from greater economic activity. I wonder how the deficit shrunk in the late 90’s when interest rates were so much higher than they are today?

  26. Through most of the last 30 years the CB has targeted inflation and inflation expectations. That’s all you really need to know.

  27. Because Volcker thought he was saving us from inflation, when he was really just like a kid in the back seat with his toy steering wheel thinking he’s actually driving the car. Oil prices tanked and that put the brakes on inflation.

    If it isn’t obvious to you yet, based on all of Cullen’s posts and MR, its that monetary policy is a very blunt tool when it comes to influencing the economy.

  28. Rates don’t always go up due to economic activity. Cost-push inflation is always a potential factor.

  29. For those inclined to look objectively not only at the failure of policy that Bernanke implements, but at the failure in logic his stated words express, I present thou with the Ben S. Bernanke Quote Of The Day:

    “One of the paradoxes is that the best way to get interest rates up is to have low interest rates, because that promotes a stronger growing economy, and that causes interest rates to rise. In some ways, the fact that interest rates have gone up a bit, and it happens on the real and not the inflation side, is actually indicative of a stronger economy, which again, suggests that maybe this is having some benefit.”

    My head hurts after reading & trying to follow this Bernanke-ism.

    Can anyone spoon feed me what I’m obviously missing, since it’s not possible that what Bernanke stated is irrationally circular?

    Thanks.

  30. Geoff, to me it makes perfect sense that its a bit of both:

    when rates are low/being cut it usually corresponds to a period where demand for credit is low. Keep rates low and demand for credit should eventually pick up but in the meantime lower rates don’t necessarily increase demand for credit.

    At the same time, the lower rates savers receive simply adds to the economic strains caused by lower lending activity.

    Of course what we need to hope is that when lending/demand for credit picks up its going into worthwhile projects that will create economic activity in the long run and not focused on pointles speculation (e.g. housing or stocks)

  31. oh Mr P, be a little more optimistic. I broadly agree with Cullen on the state of the USA (I’m a non-resident – but frequent visitor – by the way). The USA is working its way through a very rare type of recession – a “balance sheet recession”. The excesses of pointless debt-fuelled speculation are being worn away resulting in a ver weak economic environment despite massive govt deficits. Eventually the excesses will be worn away and the economy will find itself in a good old-fashioned growth period. I really don’t think they are all that far away from that – few more years.

  32. Well I think it is an oversimplification. Domestic Growth is not the only trigger of inflation. Don’t forget that currency devaluations also cause inflation. Assuming the US runs a current account deficit, current account deficits must be met by portfolio account surpluses. Foreign investors (in theory) will want to be compensated for making these investments, especially if they can find other default free investments in other places (which might be our saving grace for now)

    Government deficits contribute to current account deficits.

  33. I think the current political setting in the US is that fiscal policy can and should be used to control inflation and interest rates, at least until the US deficit is around the sum of population growth and employment or about 3% of GDP.

    After that interest rates could also be used, or fiscal policy could still be used.

  34. Eventually they usually play catchup.That is the whole idea of stagflation is you get cost push that starts on non labour inout that eventually narrows the output gap and the catchup passes to labour costs.During the process asset prices have usually dropped and then probably stagnated and eventually the ratios between buying in asset prices and the income to do so becomes favourable again. This is nothing new.

  35. There are three basic elements comprising long-term interest rates: a “pure” rate; a risk rate; & an inflation premium. The pure rate presumably reflects the price required to induce lenders into parting with their money in a non-inflationary & risk-free situation.

    Long-term interest rates are determined not only by the various supply & demand factors that affect short-term rates but also by a unique factor; namely, inflation expectations. The expectation that price levels will chronically increase injects an “inflation premium” into long-term rates.

    Under these assumptions, the present supply of loan funds would decrease (in both a quantitative & schedule sense). That is to say, lenders as a group, reduce the volume of loan funds offered in the markets, & refuse to loan any particular volume of funds (except at higher rates that will compensate for the expected rates of inflation).

    Conversely, borrowers expecting to be able to pay off loans with depreciated dollars will increase their demand for loan-funds. Higher interest rates will choke off the economy long before inflationary forces reduces the burden of debt. I.e., of the two effects, the supply side is the more important, since it literally establishes the minimum for long-term rates.

    Interest rates may respond to influences other than inflation rates, either current or expected (there is a demand side factor (government deficit financing) operating in the loan funds market as well as supply side factors (available savings – public & foreign, & debt monetized by our Central bank).

    At the same time supply is decreasing, the demand for loan funds is expected to rise as a consequence of the expected massive increases in federal deficits (for savings), (the larger the deficit, the greater the demand). The deficit financing impacts on the supply side (as well as the demand side) are pushing interest rates up or retarding their fall. But with supply decreasing in the longer term (esp. c. Aug 2013), & demand increasing (in the schedule sense), there is only one way for future interest rates to go– up.

    Interest rates will stabilize when there is an increase in the supply of, & a decrease in the demand for, loan-funds. If inflation expectations diminish, supply (in the schedule sense) will increase. Lenders will be willing to lend the same amount at lower rates, etc. The demand for loan funds will be reduced by bringing under control the new voracious appetite of the federal government for (savings).

  36. Beg. 2013, the supply of loan funds increased:

    + exogenous money – expiration of widespread FDIC insurance coverage (re-routes savings through the NBs making existing savings available for investment)

    + endogenous money – QE3’s LSAPs (@ $85b/mo = $1,020T for 2013), i.e., if the Fed doesn’t exit, existing debt is monetized

    & the demand for loan-funds has receded slightly: CBO’s projected 2013 fiscal deficit @ $845B.

    Considering these factors in isolation, & that the roc in MVt (proxy for inflation) falls until Aug 2013, longer dated securities are likely to rise further (interest rates fall).

  37. “So, don’t get too worked up over interest on the national debt or what will happen when interest rates rise because, by then, we’ll likely be talking about ways to cool down the economy….Which is a nice problem to have assuming we’re not cooling down the wrong areas”

    Cullen,
    An excellent statement, and right to the point! Remeber, how they needed to cool down the economy around 2007? That try ended nicely… Obviously, the next try will be different. Yet, I just do not see how it can be different, and I am afraid it will be much worse. If you think otherwise, please, provide some hypothetical scenario with some numbers. That, at least to me, would be much more helpful than reciting Mr. Bernanke, who always knows the exact outcomes of the future and always says the truth…..

  38. I don’t think interest payments on the debt are $1 trillion. I thought it was about $220b from the numbers I’ve seen.
    You’re making two assumptions that I find difficult to accept:
    1. You say higher deficits lead to economic growth. In this case, you are saying that if we have more interest payments on the debt, it will be good for the economy. I could see that deficit spending on roads would grow the economy; but do you think paying $1 trillion in interest to lenders is going to induce them to spend?
    2. You’re also flat out ignorning the demographics and the rising costs of Medicare, which are right in front of you. The deficit fell in the 90s when the boomers were in their high earning years. Spending is going to rise for their retirement costs.
    Look, I’m not in a bunker waiting for the world to end. But I’m not Pollyanna, either, and I think we ought to at least address the risks.

  39. “1.You say higher deficits lead to economic growth”

    Dooode, I think Keynes would agree with that statement.

    “2. You’re also flat out ignorning the demographics and the rising costs of Medicare”

    Medicare isn’t about affordability. It is about real costs. Will we have enough doctors and beds and homes to serve all those old fogies?

  40. 1. Sure, there is no guarantee that an increase in interest payments will induce the private sector to spend more, but it certainly gives the private sector a better chance of spending more, than paying less in interest. If this income is not spent, there will be no inflation, and it will be difficult to get growth, unless we see a surge in bank credit like in the 2000s.

    2. Yes, let’s talk about demographics. Who is going to provide the medical care, shelter, food,clothing entertainment, etc. for this large swath of soon to be retired citizens? The younger generations that are currently not doing so well in the employment department. And think of the added disposable income those seniors will have if their 401(k)s, pensions, savings were shored up by better yields on a risk free asset like a treasury bond.

    I don’t think anyone is disagreeing that there won’t be inflation. If there is more money in the system, whether through an increase in NFA’s or credit, beyond the productive capacity of the economy, prices will rise. What the bigger risk is to our economy, and MR has also discussed this, through not as thoroughly as Ramanan at concertedaction does, is trade deficits. Dealing with that is a whole other set of policy decisions beyond basic fiscal and monetary policy.

  41. 1. Does paying interest on debt create economic activity?
    I agree that if we run a deficit to pay off student loans or build roads that those activities would generate economic activity. But paying interest seems different, less efficient, especially if you’re borrowing to pay the interest.
    2. So long as there is demand for doctors and beds, and Uncle Sam is picking up the tab, there will be doctors and beds, imo.

  42. 1. If the government borrows money to pay off someone’s student debt or build a road, how exactly does that generate economic activity? Is it because it gives you a warm and fuzzy feeling that some one can now pursue a career without worry about debt or that smooth, wide road now gives you another option to get to work? No, the debt-free student now has more income to spend or save because he doesn’t have a student debt bill every month. And those construction workers and contractors that built that road now have more income because they got paid to do their job. Same thing happens when the gov’t pays a coupon a few bps higher than last month to their bondholders. Whether any of this stimulates economic growth is if that extra income exceeds their desires for savings and they spend a few bucks more in the economy.

  43. I don’t think they should ‘borrow’ the money. I think they ought to just pay off the lenders. Why replace one debt obligation with another?
    Why doesn’t the Fed just buy up all the student loan debt …. and, key point, let’s look at how we pay for young people to get educated.
    Cullen talked in another thread about how some borrowing is constructive and some is not. Again, I wonder if paying more and higher interest is constructive — especially if the bondholders are either foreign countries or financial institutions who will spend the money in the virtual economy.

  44. Fair point in trying to determine what is more constructive deficit spending, but these are mainly political debates. I just don’t think there are any absolute truths there.

    With regard to paying off the lenders, the government can’t just do that. They need the funds to spend. It has to come from taxes or borrowing.

  45. It only works if there is real growth to be had. If we are Japan, then there will be 20 years of zero interest rates followed by true desperation on the part of the Government.

  46. Hi Geoff,

    Yes that makes sense, along with this though I also read recently a view that QE itself (which is a tool somewhat aimed at modifying interest rates) overall reduces demand since it removes interest baring asset from the Economy.

    I guess it’s not a clear cut argument either way.

  47. >> about the country/SS/Medicare going broke like they’ve done every 5-10 years since 1965

    True, never underestimate the ability of the media to scaremonger.
    On the other hand, in 1965 SS did not have a negative cash flow either.

    It’s like when Chicken Little said the sky is falling.
    When it finally did, no one believed him.

    >> Tax receipts could outpace spending increases

    People in hell could get ice water, but it hasn’t happend yet.

    >> How did the deficit shrink in the late 90′s?

    Lower tax rates, increased productivity.
    Yes the economic pie grew, but govt grew faster.

    It’s a revenue volatility problem.

    1.) Economy Grows.
    2.) Govt grows faster, has revenue boom.
    3.) Economy slows
    4.) Govt has revenue bust

    Each year, the boom/bust cycle gets bigger and bigger.

    The Econ Dept (Mercatus Center) at George Mellon Univ. had a good article about this. The moral of the story, is that govt can not handle money any better than an alcoholic in a distillery.

    >> rising costs of Medicare

    Actually, that would be the rising cost of govt involvement.
    The private sector does not impose regulation/price-controls.
    They simply pass on, what the govt takes out of the productive sector.

    >> If the government borrows money to pay off someone’s student debt or build a road, how exactly does that generate economic activity?

    It not only does not, it sucks it out of the economy, faster that a leech sucks blood out of its victim. It makes everything more expensive. When the private sector borrows, it gets dramatically different results. It has less to do with borrowing, than “who” does the borrowing.

    >> Who is going to provide the medical care, shelter, food,clothing entertainment, etc. for this large swath of soon to be retired citizens?

    The short answer is no one – it is mathematically impossible. Technically that’s not true. In a typical investment, you would start saving in your 20’s, having 40+ years of productive gains.

    But in really, when you get your paycheck at the end of the week, the govt takes 15% for SS, then buys a case of booze and hookers, and goes to the casino. The money is gone the very next day.

    >> I’d like to see a chart that shows both interest rates and economic growth.
    See the Mercatus Center – they have lots.
    No correlation in interest rates, though.

    >> What is going to make interest rates rise?
    I’m no expert, but it’s consequences.
    They value of money is false.