NCPA - National Center for Policy Analysis

Watching Interest Rates

August 4, 2003

The Federal Reserve is always trying to figure out whether there is too much or too little money in the economy. Every six weeks it meets in Washington to review economic conditions and, if necessary, adjust monetary policy.

Right now, the Fed is unsure of what it should be doing. Its June 25 statement basically said that the odds of inflation and deflation are about equal. But because of slow growth in the economy, it decided to err on the side of deflation, which is why it cut the fed funds rate, says Bruce Bartlett.

The problem is that monetary policy affects the price level only with a long lag:

  • Also, interest rates are powerfully affected by general economic conditions.
  • If the economy is growing slowly, interest rates will tend to be low because business demand for investment capital will be low.
  • A pickup in economic growth, therefore, will tend to raise rates.

Businesses will not borrow unless they can earn a rate of profit greater than the interest rate, explains Bartlett, thus the low level of business borrowing, which has helped keep interest rates down, is partly due to the low level of profit. Low profits are due to slow growth, which means that faster growth and higher profits -- two things everyone wants -- necessarily lead to higher interest rates.

The Bush Administration argues that improving prospects for growth are behind the recent interest rate rise, a view supported by private economists as well. If that is true, Bartlett says, then rising rates -- as painful as they may be for bondholders and those seeking mortgages -- are a good thing. It means that businesses perceive better profits down the road and are borrowing more to take advantage of them. (See the figure.)

Source: Bruce Bartlett, "Watching Interest Rates," National Center for Policy Analysis, August 4, 2003.


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