What will interest rates rise to in 2011

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Related Articles. Partner Links. The monetary base, which includes these reserves plus cash, has more than doubled in the past three years as a result of the Federal Reserve's attempts to respond to the financial crisis and recession. Monetarists fear that such increases in the quantity of money portend inflation of a similar magnitude. Get ready for inflation and higher interest rates. The unprecedented expansion of the money supply could make the '70s look benign. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years.

In an interview with the Wall Street Journal earlier this year, Philadelphia Fed president Charles Plosser issued a more muted but similar warning:. We have all these excess reserves sitting in the banking system, a trillion-plus excess reserves. As long as [the excess reserves] are just sitting there, they are only the fuel for inflation, they are not actually causing inflation. While I also worry about inflation, I do not think that the money supply is the source of the danger.

In fact, the correlation between inflation and the money stock is weak, at best. The chart below plots the two most common money-supply measures since , along with changes in nominal gross domestic product. M1 consists of cash, bank reserves, and checking accounts. M2 includes savings accounts and money-market accounts. Nominal GDP is output at current prices, which therefore includes inflation. As the chart shows, money-stock measures are not well correlated with nominal GDP; they do not forecast changes in inflation, either.

The correlation is no better than the one between unemployment and inflation. Why is the correlation between money and inflation so weak?

The view that money drives inflation is fundamentally based on the assumption that the demand for money is more or less constant. But in fact, money demand varies greatly. During the recent financial crisis and recession, people and companies suddenly wanted to hold much more cash and much less of any other asset. Thus the sharp rise in M1 and M2 seen in the chart is not best understood as showing that the Fed forced money on an unwilling public.

Rather, it shows people clamoring to the Fed to exchange their risky securities for money and the Fed accommodating that demand. Money demand rose for a second reason: Since the financial crisis, interest rates have been essentially zero, and the Fed has also started paying interest on bank reserves.

But if bonds earn the same as cash, it makes sense to keep a lot of cash or a high checking-account balance, since cash offers great liquidity and no financial cost. Fears about hoards of reserves about to be unleashed on the economy miss this basic point, as do criticisms of businesses "unpatriotically" sitting on piles of cash. Right now, holding cash makes sense.

Modern monetarists know this, of course. The older view that the demand for money is constant, and so inflation inevitably follows money growth, is no longer commonly held. Rather, today's monetarists know that the huge demand for money will soon subside, and they worry about whether the Federal Reserve will be able to adjust. Laffer continues:. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates.

Laffer's worry is just that "rapid growth" in money will not cease when the "panic demand" ceases. Plosser writes similarly. Some people have questioned whether the Federal Reserve has the tools to exit from its extraordinary positions. We do. But the question for the Fed and other central bankers is not can we do it, but will we do it at the right time and at the right pace.

The Fed can instantly raise the interest rate on reserves, thereby in effect turning reserves from "cash" that pays no interest to "overnight, floating-rate government debt. Modern monetarists therefore concede that the Fed can undo monetary expansion and avoid inflation; they just worry about whether it will do so in time.

This is an important concern. But it is far removed from a belief that the astounding rise in the money supply makes an equally astounding increase in inflation simply unavoidable. And like the Keynesians, the monetarists do not consider our deficits and debt when they think about inflation.

Their formal theories, like the Keynesian ones, assume in footnotes that the government is solvent, so there is never pressure for the Fed to monetize intractable deficits. But what if our huge debt and looming deficits mean that the fiscal backing for monetary policy is about to become unglued?

You don't have to visit right-wing web sites to know that our fiscal situation is dire. About half of all federal spending is borrowed. Then, as the Baby Boomers retire, health-care entitlements and Social Security obligations balloon, and debt and deficits explode. And the CBO is optimistic. Three factors make our situation even more dangerous than these grim numbers suggest. First, the debt-to-GDP ratio is a misleading statistic. But there is no safe debt-to-GDP ratio.

There is only a "safe" ratio between a country's debt and its ability to pay off that debt. If a country has strong growth, stable expenditures, a coherent tax system, and solid expectations of future budget surpluses, it can borrow heavily. In , everyone understood that war expenditures had been temporary, that huge deficits would end, and that the United States had the power to pay off and grow out of its debt.

None of these conditions holds today. Second, official federal debt is only part of the story. Our government has made all sorts of "off balance sheet" promises.

The government clearly considers the big banks too important to fail, and will assume their debts should they get into trouble again, just as Europe is already bailing its banks out of losses on Greek bets. State and local governments are in trouble, as are many government and private defined-benefit pensions. The federal government is unlikely to let them fail. Each of these commitments could suddenly dump massive new debts onto the federal Treasury, and could be the trigger for the kind of "run on the dollar" explained here.

Third, future deficits resulting primarily from growing entitlements are at the heart of America's problem, not current debt resulting from past spending. But even if the United States eliminated all of its outstanding debt today, we would still face terrible projections of future deficits. In a sense, this fact puts us in a worse situation than Ireland or Greece. Those countries have accumulated massive debts, but they would be in good shape Ireland or at least a stable basket case Greece if they could wipe out their current debts.

Not us. Promised Medicare, pension, and Social Security payments known as "unfunded liabilities" can be thought of as "debts" in the same way that promised coupon payments on government bonds are debts. To get a sense of the scope of this problem, we can try to translate the forecasts of deficits in our entitlement programs to a present value. The idea that these fiscal problems could lead to a debt crisis is hardly a radical insight. As even the circumspect Congressional Budget Office warned earlier this year:.

It is possible that interest rates would rise gradually as investors' confidence declined, giving legislators advance warning of the worsening situation and sufficient time to make policy choices that could avert a crisis. But as other countries' experiences show, it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply.

The exact point at which such a crisis might occur for the United States is unknown, in part because the ratio of federal debt to GDP is climbing into unfamiliar territory and in part because the risk of a crisis is influenced by a number of other factors, including the government's long-term budget outlook, its near-term borrowing needs, and the health of the economy.

When fiscal crises do occur, they often happen during an economic downturn, which amplifies the difficulties of adjusting fiscal policy in response. Bernanke has been echoing this warning with a degree of bluntness very unusual for a Fed chairman. In testimony before the House Budget Committee earlier this year, he said:. The question is whether these [fiscal] adjustments will take place through a careful and deliberative process. But precisely the situation they warn about carries a significant risk of inflation amid a weakening economy — an inflation that the Fed could do little to control.

To see why, start with a basic economic question: Why does paper money have any value at all? In our economy, the basic answer is that it has value because the government accepts dollars, and only dollars, in payment of taxes. The butcher takes a dollar from his customer because he needs dollars to pay his taxes.

Or perhaps he needs to pay the farmer, but the farmer takes a dollar from the butcher because he needs dollars to pay his taxes. As Adam Smith wrote in The Wealth of Nations , "A prince, who should enact that a certain proportion of his taxes should be paid in a paper money of a certain kind, might thereby give a certain value to this paper money.

Inflation results when the government prints more dollars than the government eventually soaks up in tax payments. If that happens, people collectively try to get rid of the extra cash. We try to buy things. But there is only so much to buy, and extra cash is like a hot potato — someone must always hold it.

Therefore, in the end, we just push up prices and wages. The government can also soak up dollars by selling bonds. It does this when it wants temporarily to spend more giving out dollars than it raises in taxes soaking up dollars. But government bonds are themselves only a promise to pay back more dollars in the future. At some point, the government must soak up extra dollars beyond what people are willing to hold to make transactions with tax revenues greater than spending — that is, by running a surplus.

If not, we get inflation. If people come to believe that bonds held today will be paid off in the future by printing money rather than by running surpluses, then a large debt and looming future deficits would risk future inflation. And this is what most observers assume.

In fact, however, fears of future deficits can also cause inflation today. The key reason is that our government is now funded mostly by rolling over relatively short-term debt, not by selling long-term bonds that will come due in some future time of projected budget surpluses. Half of all currently outstanding debt will mature in less than two and a half years, and a third will mature in under a year.

As the government pays off maturing debt, the holders of that debt receive a lot of money. Normally, that money would be used to buy new debt. But if investors start to fear inflation, which will erode the returns from government bonds, they won't buy the new debt. Instead, they will try to buy stocks, real estate, commodities, or other assets that are less sensitive to inflation.

But there are only so many real assets around, and someone has to hold the stock of money and government debt. So the prices of real assets will rise. Then, with "paper" wealth high and prospective returns on these investments declining, people will start spending more on goods and services.

But there are only so many of those around, too, so the overall price level must rise. Thus, when short-term debt must be rolled over, fears of future inflation give us inflation today — and potentially quite a lot of inflation. It is worth looking at this process through the lens of present values.

The real value of government debt must equal the present value of investors' expectations about the future surpluses that the government will eventually run to pay off the debt. Bond holders will therefore try to sell off their debt before its value falls. If only long-term debt were outstanding, these investors could try to sell long-term debt and buy short-term debt. The price of long-term debt could fall by half thus long-term interest rates would rise so that the value of the debt would once again be the present value of expected surpluses.

But if only short-term debt is outstanding, investors must try to buy goods and services when they sell government debt. The only way to cut the real value of government debt in half in this situation is for the price level to double. In a sense, this confirms the Keynesians' view that expectations matter, but not their view of what the sources of those expectations are. A fiscal inflation would happen today because people expect inflation in the future.

A "loss of anchoring," to use a Keynesian term, would thus likely to lead to stagflation rather than to a boomlet of growth. The Treasury probably borrows using short-term bonds because short-term interest rates are lower than long-term rates. The government thus thinks it's saving us money. But long-term rates are higher for a reason: Long-term debt includes insurance against crises. It forces bondholders to bear risks otherwise borne by the government and, ultimately, by taxpayers and users of dollars.

Like all insurance, a premium that seems onerous if there is no disaster can seem in retrospect to have been remarkably small if there is one. Trial Try full digital access and see why over 1 million readers subscribe to the FT. For 4 weeks receive unlimited Premium digital access to the FT's trusted, award-winning business news. Digital Be informed with the essential news and opinion.

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