What are the implications of higher interest rates?
By Scott Sumner
The Mercatus Center has a new colloquium on the current low interest rate environment, and the implications of higher rates in the future. My contribution discusses four possible ways that interest rates might rise:
1. Tighter money
2. Easier money
3. Fiscal stimulus
4. Pro-growth (supply-side) policies
This is an area rife with “reasoning from a price change.” If someone talks about the Fed “raising interest rates next week”, then in context it’s pretty clear that they have in mind the first option—higher rates via a tight money policy. But if they say that the Fed should move the US away from the low interest rate environment of the past 8 years, I have no idea what they are proposing. Would that be achieved via an easier money policy? Or a tighter money policy? I’d argue that an easier money policy is more likely to raise interest rates over the next decade, but in many cases people seem to have something else in mind.
The same is true of fiscal policy. There are two different ways that fiscal stimulus might push interest rates higher. A bigger budget deficit would require more federal borrowing. This would depress bond prices and raise bond yields. However the effect is likely to be quite modest, as the global credit markets are very large relative to the size of the US budget deficit.
Alternatively, a cut in marginal income tax rates (plus deregulation) might boost economic growth. This would increase the private sector’s demand for credit, and push up interest rates. Unfortunately, much of the recent discussion has blurred these various factors together; making it hard to see which mechanism is being proposed.