Wednesday, April 4, 2012

Price Inflation Before Higher Interest Rates

A couple of weeks ago, I wrote on the topic of interest rates.  I asked if we were seeing the beginning of rising rates.  Interest rates, like the 10-year yield, jumped higher in a short amount of time.  Since then, the rates have retreated slightly, although the 10-year rate remains above 2% as of this writing.

One thing I failed to mention in that post is that we are not likely to see significantly higher interest rates until we see significantly higher price inflation.  In other words, I don't expect to see the 10-year yield to double or triple until we see much higher consumer price inflation.  We might see the 10-year yield go to 2.5% or even 3%, but I don't expect it to go to, say, 6%, unless we see substantially higher consumer price index (CPI) numbers.

The reason for this outlook is the Federal Reserve.  If the rates start to creep up more, I would expect the Fed to start buying more government debt, particularly longer-term bonds.  Whether they call it QE3, Operation Twist, or anything else, I would expect the Fed to buy longer-term bonds.  This will put a lid on interest rates.  I would not expect to see a Bernanke Fed sit on its hands and do nothing in the face of rising rates in the current environment.

The one scenario where I see the Fed sitting on its hands is if we see a big spike in consumer prices.  I understand that things like food and gas are already going up at a decent clip.  I understand that the CPI is not the most accurate measure of price inflation and may be swayed to understate the number.  But generally speaking, price inflation is not huge right now.  It is not like the 1970's yet.

Big price inflation (let's say 10% or more) is the one thing that could stop the Fed from buying more government debt.  While many libertarians disagree with me on this point, I think the Fed will stop the monetary inflation if the dollar is severely threatened.  It does not make any sense why the Fed and bankers would allow a situation of hyperinflation.  This would destroy the division of labor.  They would be committing financial suicide to go this far.

So the one situation I can see where the Fed would allow rates to rise would be in the face of severe price inflation.  The Fed will probably choose to save the dollar.  At that point, interest rates would go up.  We would see an unwinding of all of the previous malinvestment.  We would see a severe recession or depression.  The federal government would finally be forced to cut back on its massive spending.

In conclusion, we should watch the CPI just as carefully as we watch interest rates.  If the CPI remains around 2 to 3 percent on an annual basis, then the Fed can keep holding rates down.  Once bigger price inflation kicks in, then the Fed will have to make a decision to stop or severely cut back its purchases of government debt.  Then we could see much higher interest rates.

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