The Relationship Between Interest Rates, Inflation, and the Economy

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The Federal Reserve took extraordinary measures to lower interest rates during the Great Recession. Image by the U.S. Government.

Everything that goes up must come down. But there comes a time when not everything that’s down can come up — George Burns

If you’ve purchased or refinanced a home, bought a car, or carried balances on a HELOC during the past seven years, you can thank the Federal Reserve for putting serious money in your pocket, courtesy of an unprecedented period of low interest rates.

The flip side of the coin is individuals dependent upon savings, who have seen their returns dwindle to virtually nothing.

Meanwhile, although the economy has been grinding along slowly since the end of the recession, speculative assets such as stocks and investment real estate have soared in value.

What does it all mean, and more importantly, what’s in store for the economy?

The Federal Reserve Took Extraordinary Measures to Fight the Recession

As the Great Recession of 2008-09 chilled the U.S. economy, the Federal Reserve began a series of maneuvers to soften the blow:

  • Short-term interest rates were reduced ten times between September, 2007 and October, 2008.
  • Quantitative Easing — phased Federal Reserve purchases of government securities to drive down long-term interest rates — was aggressively employed.
  • Lending institutions were provided lines of credit to help spur consumer loans.
  • Loans were provided to finance the takeover of Bear Stearns and AIG, and to certain foreign countries in which the U.S. was export-reliant.

Although substantial in dollars, the last two bullet points have long since been retired. It’s the first two that threaten the U.S. economy today.

The Goal of Monetary Policy During Recessions

The Fed has a limited number of  tools at its disposal to combat recessions. Lowering interest rates is the most common tactic deployed, and arguably the most effective.

Commercial loans, for example, are typically priced to the prime rate with a modest margin. Before the Fed began taking action, the prime rate was 8.25%, meaning many loans had starting rates of 10% or greater.  Needless to say, now that prime is 3.25% and the economy is growing again, loan demand is strong.

Although there is an obvious correlation between lower interest rates and willingness to take on debt, the relationship has the potential for a nasty side effect: inflation. According to an article entitled “Money Supply” by economist Anna J. Schwartz, the cycle works as follows:

An increase in the supply of money works both through lowering interest rates, which spurs investment, and through putting more money in the hands of consumers, making them feel wealthier, and thus stimulating spending. Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labor and raises the demand for capital goods. In a buoyant economy, stock market prices rise and firms issue equity and debt. If the money supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits. As the public begins to expect inflation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans.

So far, there has been no significant impact upon the Consumer Price Index (CPI), which stands at below 2% today. Is that likely to remain the case?

Excessive Money Supply Increases Inflationary Pressures

As stated in Schwartz’ piece, a rapidly expanding money supply increases the risk of rising inflation. Although M2 in the United States doubled between 1984 and 1998, GDP grew nearly 60% over the same period, sufficient enough to absorb the increase without spurring excessive inflation. By contrast, the Fed’s pumping $3 trillion into the economy between 2007-14 resulted in a 53% increase in the money supply, but only a 16% growth in GDP.

In short, the economy has proven it can shrug off an increasing money supply when it  is humming along nicely. What remains in doubt is whether or not it can do the same during this heavy intervention/slow growth era.

Low Interest Rates and Speculation

With interest rates on savings accounts and other liquid investments low, more and more investors are turning to speculation in order to earn real returns.

The Dow Jones Industrial Average, for example, has more than doubled since plunging during 2008-09. The NASDAQ has nearly doubled as well. Multifamily construction and overall demand is booming. Needless to say, those with sufficient wealth and discretionary income to significantly invest in these sorts of assets are doing much better today than those who don’t, further exacerbating income inequality in the United States.

What’s in Store for 2015 and Beyond?

Federal Reserve policymakers have long stated that their intention is to begin raising interest rates starting somewhere around mid-2015. The reason is simple: rising rates will slow the demand for debt, reducing the danger of out-of-control inflation striking the U.S. as it did a generation ago.

But as we already know, everything that goes up must come down. Or maybe not. As William Harvey once said, “All we know is still infinitely less than all that remains unknown.”

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