Should We Be Afraid of Rising Interest Rates?

Recently, interest rates have been rising. The 10-year government bond rate, which is highly correlated with mortgage rates, has gone from around 2.5% to 3.0%. Some in the media have been assuming that this is a warning sign of future problems, most notably inflation associated with the Federal Reserve's efforts to push the economy to a faster growth rate (called Quantitative Easing 2, or QE2). In their view, QE2 has not had, nor will it have, much if any positive effects on growth. They presume its effects will be entirely felt with the rate of inflation.

The recent run-up in the stock market, which began when QE2 was first announced, certainly argues against the no growth impact view. What forces generally drive interest rates higher? In general (but not always), interest rate rise for:

• increases in the rate of economic growth;
• higher levels of actual or expected future inflation; and
• monetary tightening.

Note that the first two are often related -- higher growth does at times generate higher inflation.

I don't want this post to be a substantial debate about the direction inflation is going to go, because economists really don't know the answer with much certainty at present. Instead, let me provide you with something to reflect on concerning the speculation by the media that interest rates are rising very sharply -- it is called historical perspective.

The chart shows the 10-year government bond rate since the late 1980s (click to enlarge this image). First thing to note: the value on the right must be divided by 10 to get the actual interest rate. So the most recent value, 30.0, really means a rate of 3.0%.

As this graph shows, while the 10-year bond rate has recently increased, it is very far below either historical values (the high was 8.25% in 1991) and the trend value at present (6.3%).

Recent Interest Rate Increases Have Been Exaggerated by the Media

Is the recent increase something to be worried about? Rates are still extremely low by historical standards at the present time.

So, how likely is it that this rate will jump and approach its current trend value or higher? The way you should approach this is to ask what it would take for this to occur. Don't merely assume that it will occur. In other words, critique what you hear from the media.

Thus, dramatic increases in economic growth or inflation would be required for this to occur, using the three factors above, since monetary policy isn't about to tighten any time soon. I think it is safe to say that the US is not about to move in hyper drive when it comes to economic growth. We are very likely stuck in the 2-3% growth range for some time to come. Will inflation take off? While it is true that the US dollar has weakened somewhat since QE2 began, which causes commodity prices to move higher (this is why gas prices are now at or above $3 per gallon, for example), this by itself isn't enough to fuel a large increase in inflation. Economic strength in developing countries (like China, India, and Brazil) is a major contributor to rising commodity prices, given the recent changes in the value of the US dollar.

The recent increase in the 10-year government bond interest rate is thus related to the acceleration of economic growth -- in both the US (note the improving economic statistics recently) and in developing economies. Recent increases in commodity prices are inflationary. But for inflation to be impacted, these price increases would have to continue through time. Weakness in Europe and Japan will moderate inflation pressure in the coming months, as will ongoing productivity growth, which provides employers with a cushion as input costs are pushed higher by rising commodity prices. Can recent rates of increase in economic growth be sustained here and in developing countries? That remains to be seen.

Persons (and the media) in the US often don't think globally. They attempt to explain everything in terms of what is currently happening in the US. If you want to grasp what is really going on with many important economic variables, like interest rates, it is necessary to consider a global context and several different but related markets. Welcome to the new world!