On Interest Rates, Inflation, and the Business Cycle

If you have read the first few posts on this blog, you have surely noticed that I talk about interest rates a lot, and inflation only a little. If you know nothing about rate structures, or wonder why I don’t equate these two terms when they sound very much alike, this post is for you. I will go into both the Keynesian view and my personal view of how interest rates, inflation, and employment are all connected.

I will start with the Fed and Money. You’ve seen me talk about money before, about how it has no intrinsic value and how it only serves as a function of exchange. The Fed controls the Money Supply through various operations, both direct and indirect. Some indirect methods are dictating how much money banks can lend out (the Money Multiplier) versus hold in reserve (Reserve Requirements), and these park money in the banks so it cannot circulate through the economy. Direct methods are more, as you can tell, direct, where the Fed itself steps in to limit or grow the Money Supply. Some of these methods are printing money (or, as an extension, easing credit requirements), or what’s known as Open Market Operations, where the Fed buys and sells Bonds (usually treasuries) on the open market (the secondary bond market that we all use to invest). The most prominent feature in the Fed’s policy arsenal is the setting of the Federal Funds Rate (FFR), which is the lending rate on overnight deposits from banks to other banks, as well as from banks to the Fed itself. The FFR is presented in a range, and currently sits at 1.00% – 1.25%, showing a 1.00% deposit rate from bank to bank and a 1.25% rate from bank to Fed.

You may recognize that Open Market Operation method as the Fed’s role in the 2008-2009 housing market collapse, where many billions worth of mortgage bonds went underwater and the Fed purchased then in rounds of Quantitative Easing. The Fed does this in times of extreme cash crunch, or liquidity crunch, where the worry is that money will rapidly exit the economy and stimulate Deflation, rather than Inflation.

The Treasury has operated on deficits for as long as any of us can remember, and they finance through treasury bonds. These are sold in fixed intervals and their rates are easily tracked. The different types of treasuries sold are denominated by time until maturity. with the shortest being 4 week Bills, and the longest being 30 year Bonds. Interest rates on this debt is influenced by a number of factors I will go over shortly, but in general, investors will expect a higher interest rate for bonds with longer time until maturity. The scale of different rates for different term bonds is called the Yield Curve.

Inflation, Deflation, Mortgage bonds, Yield Curves, what does all this have to do with the topic of the post? All of it is connected as the economy moves. Let’s assume that the economy has just come out of a recession, and businesses are ready to grow and hire again. The banks need to be able to lend those businesses more money, so the Fed will do some variation of loosening credit requirements, lower the Federal Funds Rate, or conduct Open Market Operations so there is more money in the economy (buying bonds). Businesses take that easier money and either expand their operations (investment) or hire more people. As more people are hired, the unemployment rate goes down, so the Supply of Labor does the same. Bear in mind that in the upward portion of the business cycle, Demand for Labor is going up while Supply goes down. This results in the Price of Labor (wages) being pushed to a higher level, as businesses need to compete more heavily for the same workers (typically in the form of higher wages, benefits, upward mobility, etc.).

As people make more money working, they can spend a greater quantity of that money on goods and services. This is where I believe inflation comes from, because I view economics from the Demand side first. The Keynesian view of inflation shows that consumer demand serves to ‘push’ inflation up, more than producers can ‘pull’ it. For example, if Microsoft releases a new gaming console but prices it high enough to where only a small portion of the consumer base can afford it, then Microsoft will have to lower the price to a more reasonable level. But if the price was in an affordable range for most of the country, then so many more people would want to buy the console that Microsoft could be justified in raising the price a small amount. It is in this way that consumers dictate inflation by their spending more than producers dictate it by their pricing.

As the business cycle moves along and the economy begins to do well, The Fed begins to worry about the economy doing ‘too well’. Why do they do that, you ask? The answer, predictably, has to do with inflation. As consumers do better and can spend more money, there is always the risk that inflation can become too large, causing price movements that are not justified to consumers. This makes them stop spending as much money, which hurts businesses and causes them to cut expenses(lay off workers). One of the Fed’s congressionally mandated goals is to achieve full employment, so it will take steps to combat inflation when it gets too high. It does this by doing the opposite of what it did as the cycle was starting, some variation of raising the FFR, selling bonds on the open market, or tightening restrictions on credit. All of this serves to take money out of the economy and loosen inflationary pressures.

As interest rates rise (due to the FFR pushing up minimum rates and there being more bonds on the market) the cost to borrow becomes greater, and businesses will not continue to expand and hire. Consumers will have greater incentive to save their money in vehicles that take advantage of those higher rates, rather than spend it, so consumption will decrease, and with it, business profits. Those businesses will trim their expenses and lay off workers, causing the economy to shrink. The Fed then starts the cycle over again with policies designed to make money looser and stoke inflation, so businesses will begin to hire and people will begin to spend again.

There are many subtle pushes and pulls on interest rates to make them not perfectly reflect the state of the economy. Bond investors will buy and sell if they think rates are too high or low, and traders will do the same on price. These are not perfectly liquid markets. Sometimes, as expectations about the economy doing well in the long term lessen, while expectations for the short term improve, the Yield Curve will invert, meaning lower-term bonds will pay more than higher term bonds,

Overall, though, I believe interest rates are a good gauge on employment and inflation pressures and the state of the economy in general. Treasury rates are used as benchmarks for other interest rates all over the world and in the US, with Savings accounts tracking short-term bills with expiry in less than 1 year, to Mortgages tracking the 30 year treasury bond. The bond market can tell us a lot about where expectations are for consumer spending, business hiring, and the overall state of the economy. To see this information for yourself, feel free to visit the websites I have listen on the sidebar of this website! And stay tuned for more in depth posting about all the terms gone over in this post.

Categories: Economics

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