Higher interest rates are coming. Last week, financial markets got a bit of a jolt when they suddenly realized this fact. Some analysts are now predicting fairly substantial increases by yearend. It is important to understand why rates are rising in order to assess their impact. In the short run, the effect may be to bolster growth.
Interest rates basically rise for 2 reasons. The first is that the demand for funds exceeds their supply. For example, on the demand side, growth in the economy may raise the return to capital, thus encouraging additional borrowing by businesses for investment. Or government deficits may crowd private borrowers out of the market. On the supply side, the Federal Reserve may restrict the money supply or foreigners may cease investing in dollar-denominated assets because of a falling dollar.
The second reason why interest rates rise is because of expected inflation. This cause was first identified by the great economist Irving Fisher and is often called the Fisher effect. He observed that a one percent higher expected inflation rate tended also to raise interest rates by one percentage point. This is because lenders demand compensation for the fact that the future interest and principal they receive will not be worth as much as the money they lend, in terms of the goods and services it would purchase.
It is important for policymakers to understand that the Fisher effect can cause rates to rise even when the budget is in balance or when private borrowing is falling. It is simply a function of inflationary expectations. And inflation is, in the long run, entirely a function of monetary policy. Prices for certain things may rise at any time. But the general price level can only rise for more than a brief period if the Federal Reserve pumps too much money into the economy.
The Federal Reserve has had a highly accommodative monetary policy for more than 3 years. This was justified by the Fed's previous tight money policy, which brought about the stock market crash and the following recession. By restricting the amount of money and credit in the economy, the Fed put downward pressure on prices, creating deflation, the opposite of inflation. But now many analysts believe that the Fed has more than made up for past deflation and is now sowing the seeds of inflation.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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