The Cost Of Low Interest Rates

There is a interesting short paper written by Ryan Faulkner that is available for download at Faulkner Capital or at Barclay Hedge (registration required). In the paper, Faulkner discusses the cost and consequences of the FOMC's decision late last year to lower interest rates and keep them low. While Faulkner recognizes that lower rates have provided short-term relief for the financial markets in the wake of recent credit problems, he argues that the consequences of price instability will present consequences for the markets that may have longer lasting negative effects.

Faulkner provides a comparison to the problems of the mid-1970s (I know, the stagflation comparisons are everywhere, but hang in there). At this time the real federal funds rate was negative. During, and shortly after this period, commodity prices increased rapidly. Now fast forward to 2001 and a similar trend was developing - the real federal funds rate was also negative, and commodity prices began their assent upward to the point that in June of 2004, commodity prices were rising on average 13.5% over the previous 12 months.

As rate increases took the fed funds rate from 1.0% to 5.25%, prices for commodities began to decelerate, but the move was short-lived as the Federal Reserve began drastically cutting rates in September of 2007. Not surprising, commodity prices once again took off, with real prices rising 31.9% from May 2007 to May 2008. In fact, while numerous reasons are often given for higher commodity prices, empirical studies looking at the data show that commodity prices can be modeled as a monetary phenomena (see Barsky and Kilian, 2000). Often the rise in commodity prices were either directly or indirectly driven by monetary expansion.

Of interest is that during economic expansions, it is normal that demand for commodities will increase, with commodity prices following suit. Yet if monetary policy is such that it continues to encourage growth beyond what is normal for the economic environment, then markets run the risk of entering bubble territory, such that demand and prices continue to rise, even when not justified by current economic activity. We certainly appear to be entering, or are in the midst of such a reaction to low interest rates. How do we get out of this cycle? Two scenarios come to mind and are mentioned by Faulkner. For one, the Fed could begin raising rates, but the impact on the credit markets, and subsequent fallout for the entire economy, is difficult to predict and something the Fed appears to believe is not the best course of action, or simply something they are unwilling to risk. As an alternative, the Fed could continue to keep rates low, but this scenario is likely to cause the markets to take matters into their own hands, such as selling Treasuries in mass as inflation continues to rise.

Given recent Fed moves, it is likely that the markets will need to take matters into their own hands. Regardless, the impact and repercussions may be long lasting and are likely to repeat themselves if the Fed continues to give the impression of being more interested in managing quarterly GDP numbers, and less on controlling inflation and supporting the dollar for fear of occasional lower growth. Granted, the current Fed has its hands tied somewhat, so current motivations may be based more on walking the credit tightrope, and less on any long-term bias. Only until the current credit issues are behind us (or at least manageable), and commodity prices are somewhat controlled (it is too soon to tell if the current correction will continue and last), will we get to see whether the current Fed chairman is of the Alan Greenspan or Paul Volcker mold, or some hybrid in between. In the mean time we have to wait and hope that no rate move is the right move.

Reference:
Barsky, R. B., and L. Kilian, "A Monetary Explanation of the Great
Stagflation of the 1970s," NBER Working paper, 7547 (http://www.nber.org/papers/w7547), 2000.