Interesting Lies

Why Interest Rates Tell Lies About Inflation, Growth And Just About Everything Else

By Jerry Bowyer

The job of an interest rate is to tell us the truth about ourselves.

Interest rates are a kind of statistical mirror of the nation. If we are a nation of savers, interest rates tell us that by falling. If we are a nation that lives for the moment, consuming all we make and then some, interest rates will reveal that uncomfortable fact to us by rising. If we are a nation of promise breakers who borrows with no sense of the moral imperative to repay, our IOUs become worthless. If our word is our bond, bonds rise. If our word is not our bond, then bonds fall. If we prefer to have our central bank do our defaulting on our behalf, then eventually inflation risk premiums will reveal themselves throughout the yield curve.

Yes, interest rates tell us the truth about ourselves, and that’s exactly the problem. You see, we don’t want to hear the truth about ourselves. We can’t handle the truth. And like any dysfunctional system that can’t handle the truth, we need an enabler.

Our chief enabler is our own central bank. When credit is short because capital accumulation is not occuring, our central bank creates credit out of thin air. When savings rates rise, but savers hoard, rather than invest, the central bank pushes its newly created money out of short-run credit markets and out into the whole yield curve. They don’t try to deal with the underlying problem, which is that holding high cash balances are a rational response to anti-wealth creation policies and regime uncertainty. They simply declare the existence of an unexplained  “liquidity preference” because of a lack of Keynesian “animal spirits” and tell us that the only way to get out of a “liquidity trap” is easy money, and then they rev up the printing presses once again, as they are doing now.

But if large businesses are holding on to money, they have a reason to do so. And it’s not “greed.” Greed doesn’t cause you to save money in cash accounts yielding nearly zero percent. Fear does. But for the government to admit that it has caused a climate of fear is to admit an uncomfortable truth, and they can’t handle the truth. So they print money to tell themselves and us a lie, just as easy Fed policy and massive purchases of Treasury securities tell the government the lie that it is creditworthy.

One of the biggest lies that interest rates are telling us at the moment is that there is little danger of inflation in the United States. Two  commentators in particular have been making this case: Carpe Diem blogger Mark Perry of the American Enterprise Institute and New York Times columnist Paul Krugman. One of them is a terrific economist and the other one has a Nobel Prize. Both believe that the fact that the spread between inflation protected treasury bonds (TIPS) and conventional Treasury bonds is very low, indicates that the danger of inflation is quite low.

The reasoning behind this is that the difference between an interest rate which has to compensate you for the risk of inflation and an interest rate that does not have to compensate you for that risk is a measure of the market’s estimate of inflation risk. It is often called “inflation expectations” or sometimes the “break even rate.”

This argument would make perfect sense if Treasury bond rates were set by the market. But they are not. Treasury bond rates are set by government, and in the current situation the government’s policy has been to buy massive tranches of Treasury bonds as part of two rounds of quantitative easing. When the Fed buys almost a trillion dollars worth of bonds, unsurprisingly that sudden influx of money drives bond rates down to incredibly low levels.

The thing that is remarkable is not that the Fed can push rates down, but rather that someone could look at America’s tortuously distorted yield curve and think that the message it sends is the message of the market. Krugman, in fact, has gone so far as to argue that free-market economists are hypocritical because we don’t believe what the Treasury bond market is telling us. What market? The whole point of the QEs is for the Fed to expand its interest rate policy influence to the whole yield curve.

The statistics bear this out: The inflation expectations metric based on the spread between treasuries and TIPS correlates very badly with inflation, in some cases as badly as negative 80%. This is exactly what Hayek told us to expect. Inflation reflects itself first in a lowering of the actual rate of interest beneath the natural rate. The initial phase of inflation is low bond yields, then as the boom reveals itself to be false and price inflation begins to work its way into the system, rates rise to reflect inflation risk.

Probably the worst thing about all of this is that the Fed itself has been using this distorted metric to argue for easy money, claiming in several recent FOMC statements that there is subdued risk of inflation partly because the inflation expectations are low. How could they be so blind? Can’t they see the circularity of their argument? They set the rates! And then they use the rates which they’ve set to claim that the market does not see a risk of inflation. But the market does see it.

Gold prices are not set by government edict and even after the massive recent sell-offs, gold is still screaming “inflation”  to anyone who will listen. And as food prices continue their rise, the inflationary reality will over time become impossible to ignore, even by economists.