Which Way Interest Rates?

 

The Bank of Canada first wanted us to believe that they could hold inflation to 2% per year. This was supposed to be a maximum, not a target. Even while they were expanding the money supply by 33%, they said with a straight face that inflation (by which they meant us to understand price inflation) would be held to 2%. Our Minister of Finance wanted us to believe that prices would actually drop, presumably because demand would drop. Of course, one might expect that when people are staying home and not working as much, they might pare down their purchasing. Yes, one might expect that……if money wasn’t falling into their laps from mailboxes across the land. Suppose you are at a cash auction with 49 other people and that each of you has brought $10,000 to spend --- $500k in total. The most the goods being sold can fetch is $500,000. Now suppose, someone flits through the room, handing another $10k to each of you. What do you think will happen to the prices the auctioned goods will obtain?

So now, price inflation is galloping to catch up to monetary inflation and the Bank of Canada wants to do something about it. It’s the same story in the USA with the American counterpart of the Bank of Canada --- the Federal Reserve. Both central banks are now set on raising interest rates. But when price inflation is running at historic highs (if you adjust for the changes made to how the CPI is calculated), even a fairly large increase in interest rates will still leave real interest rates negative. That means lower than the inflation rate. So the central banks are raising rates modestly to encourage people to save. Somehow, people should be motivated by a negative yield.

Paul Volker stifled inflation 40 years ago by raising interest rates to 20%. I remember a forecaster named Morgan Maxfield predicting those 20% interest rates, and then Maxfield was killed in a plane crash. Will interest rates go up again to 20%?  I don’t see how. The difference between 40 years ago and now is that back then, government debt tended to be 30 year T-Bonds. Now a huge portion of it is one year T-Bills. Back then, mortgages tended to bear fixed interest rates, but now many have variable rates. Raising interest rates to a point where they would actually bring price inflation back into line (by inducing people to save rather than spend, thereby slowing the velocity of money) would bankrupt governments and render a huge portion of homeowners insolvent.

I think we are in for a long period of price inflation. If we enter into an economic depression, which could easily happen, demand might drop enough to bring prices down, or maybe it would be an inflationary depression. It will be interesting to see what happens.