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Where Would Interest Rates be Without Fed intervention? - Real Time Insight

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The price of most things is determined by supply and demand, but sometimes governments put their thumb on the scale, so the price is not what the supply and demand fundamentals would predict. If prices are artificially held high, gluts develop, if held too low, shortages. Interest rates are also a price, the price of money. The supply is the desired amount of savings by corporations, individuals, and occasionally governments (when they run surpluses). The demand is the desire to borrow, mostly to invest, or when governments run deficits.

The Federal Reserve has been putting its thumb on the scale to keep interest rates low. If can do this effectively for short term rates, but historically long term rates have been market driven. Short term rates can help determine long term rates, after all if you want to have money in two years, you have a range of options. One would be to buy a two year note. The second would be to buy a one year note, and then roll it over in a year, or roll 90 day T-bills eight times. With Operation Twist, the Fed has tried more explicitly to bring down longer term rates.

Consumers have had a major hit to their wealth in the form of the loss of about $7 Trillion in home equity since the peak of the housing bubble. The asset shrank, but the liabilities stayed in place, so their balance sheets deteriorated and they are now trying to rebuild them. That has meant slower demand. That slower demand in turn has lead businesses to cut back on investment. Why expand capacity if a lot of your existing capacity is sitting idle and the customers are not going to be there. The government however is running large deficits, and thus is a big source of demand for "investment" funds.

Thus, I think that interest rates would be low in any case. Where would they be if there were no government or Fed action to put the thumb on the scales? While investment in equipment and software has been strong, the same has not been true for business investment in structures. While there is a lot of complaining about the low amount of interest income savers have been getting, there is not much evidence that people have stopped saving because of that (and paying down debt is a form of saving).

What interest rate, say for five years, would be needed to match up the desired amount of savings with the desired amount of investment. My guess is that it would not be all that much higher than the current 0.92%. What are your thoughts?

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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