"Kee" Points with Jim Kee, Ph.D.

Clearly, the top news from last week was the 236,000 new jobs from the nonfarm payroll number for February. Anything over 200,000 is going to move the market up, and that’s what we saw. Monthly data is “noisy,” so I wouldn’t read too much into that number, but it is good news!

 

I am increasingly asked what I think about interest rates, now and going forward. I thought I would take a stab at that for this week’s Kee Points:

 

Be an Interest Rate Expert in Fifteen Minutes: In theory*, interest rates are comprised of the following three components. None of these three components can be measured directly—they have to be estimated or inferred:

 

1)    The underlying real rate: Back in the times of the Classical economists (18th and 19th centuries) when most money was a commodity money like gold and silver, high interest rates were normally a sign of growth in a country, while low interest rates reflected anemic growth. There was little in the way of inflation expectations, so interest rates were more or less determined by the supply and demand for loanable funds. High rates were a sign of strong demand. That’s the way to think of the underlying real rate today—it is low because global demand is still pretty weak.

 

2)    Inflation expectations: When inflation is expected to rise, it means that people who lend money expect to be paid back in dollars (currency) that are worth less, so they demand more of them. That means they charge a higher rate of interest on loans – because they need more future dollars -which are worth less - to compensate them for lending their current dollars, which are worth more.

 

3)    Term premium: A bird in the hand is worth two in the bush. Loaning money to someone for a long period of time is risky – you might never get paid back because of uncertain future events. In contrast, loaning someone money for a day is less risky because you can be more certain of the borrower’s ability to repay tomorrow. So, in general, long-term rates tend to be higher than short-term rates, because lenders demand to be compensated for the riskier nature of making long-term loans. That’s called the term premium.

 

If you understand the above, then you can understand Fed Chairman Ben Bernanke’s recent talk at the San Francisco Fed, “The Past and Future of Monetary Policy.” It is available on the Fed’s website, and I think it is the best primer on understanding interest rates out there (it only takes about 10-15 minutes to read). Bernanke suggests that interest rates are low globally, and not because (or just because) of easy monetary policy by the world’s central banks or because of some “global devaluation contest.”  He makes the case that rates are low because (1) underlying real rates are low because global demand is still pretty weak, (2) global inflation expectations are well anchored and low, and (3) the term premium is low, partially because central banks are buying debt securities. Bernanke’s point is that central bank actions are mostly affecting one component of interest rates—the term premium. His view is that as the economy recovers, interest rates will rise because the real rate will go up, driven by the demand for funds, and because the term premium will start to rise as central banks exit their bond-buying programs. Assuming inflation expectations remain anchored; this should result in a gradual rise in global rates, not a collapse in bond prices and spike in rates. 

 

*Of course, you can’t start a sentence with “In theory” without referencing Yogi Berra, who said, “In theory, there is no difference between theory and practice.  In practice, there is.”