Interest Rates

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    Will the market at some point overpower the Fed’s ability to keep interest rates low? What types of things could cause rates to rise despite the Fed’s efforts?


    In our current circumstances, there are two factors that will push up interest rates despite the Fed’s efforts to hold them down.

    First, a return to normalcy on the demand-side of credit markets. Entrepreneurs are still holding back their investments in the face of uncertainties they perceive. When demand for credit returns to normal, it will put upward pressure on interest rates. Of course, the banking system has plenty of excess reserves upon which it can create credit, which would moderate the upward pressure on interest rates. Whether or not banks begin to lend normally depends on their assessment of uncertainty in extending loans.

    Second, renewed price inflation will push up interest rates. Entrepreneurs are still holding money in the face of the uncertainties they perceive. When their normal money demand is restored, price inflation will pick up. When banks begin the normal process of creating credit on their excess reserves, then the money stock will increase which also puts upward pressure on prices.

    There’s not much the Fed can do to control an entrepreneurial decline in money demand and there’s not much their willing do to control renewed credit creation by banks. Reversing their QEs and thereby, removing the excess reserves from banks, risks igniting a secondary downturn. With Yellen in charge, the Fed will undoubted err on the side of price inflation and not risk price deflation. Significant price inflation will boost interest rates.

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