Watching interest rates

Posted: Aug 01, 2003 12:00 AM

Largely unbeknownst to the general public, the bond market has been collapsing in recent weeks. For some odd reason, the liberal media have failed to trumpet this news as proof that President Bush's economics policies have failed. It may be because the reason is potentially very good.

The bond market is really the interest rate market. Contrary to popular belief, banks do not set interest rates. Rather, they are established in the process of buying and selling bonds in the same way that prices for stocks and commodities are determined.

There are many types of bonds -- corporate bonds, municipal bonds, mortgage-back securities and others. But the central market is that for U.S. Treasury securities. Because they are assumed to have zero risk of default, they are the benchmark against which all other bonds and interest rates are compared.

The key rate is that for the 10-year Treasury bond. In part, that is because many mortgage rates are set based on it. The yield on this key bond reached a low of 3.13 percent on June 13. Since then, it has risen quite sharply. By July 29, the rate had risen to 4.42 percent -- an increase of 40 percent over a very short period of time.

Rising rates mean big losses for those holding bonds because bond prices move inversely. For example, if the interest rate were 5 percent, a newly issued $100 bond would yield $5 in interest per year. If the interest rate later rises to 6 percent, then the price of that bond has to fall so that $5 of interest equals 6 percent of what you pay for that bond. In this case, the bond price would fall to about $83. Conversely, bond prices would rise if interest rates fell.

A precipitating factor in the bond market's fall was the Federal Reserve's meeting on June 25, where it reduced a key short-term rate by 25 basis points (0.25 percent). Markets had been expecting 50 basis points because the Fed had signaled a continuing concern about deflation -- falling rather than rising prices.

Expectations of inflation and deflation are critical to the bond market, because inflation reduces the real value of both principal and interest, while deflation raises them. Economists assume that long-term interest rates rise in step with inflationary expectations -- 1 percent higher expected inflation should raise long-term rates by 1 percent almost immediately.

While commentators often talk about the Fed setting interest rates, this is not really true. It can control one very specific rate called the federal funds rate, which is the rate on overnight deposits that banks loan to each other. The Fed controls this rate by increasing or decreasing the money supply on a day-by-day basis to hit its target, which right now is 1 percent.

The fed funds rate affects longer-term rates only indirectly. It is mainly a signal of how expansive or restrictive money supply growth is. If the money supply grows too slowly, it is deflationary, which can slow business activity and aggregate growth in the economy. If it grows too fast, we can end up with inflation.

The Fed is always trying to figure out whether there is too much or too little money in the economy. Every 6 weeks, it meets in Washington to review economic conditions and, if necessary, adjust monetary policy.

Right now, the Fed is unsure of what it should be doing. Its June 25 statement basically said that the odds of inflation and deflation are about equal. But because of slow growth in the economy, it decided to err on the side of deflation, which is why it cut the fed funds rate.

The problem is that monetary policy affects the price level only with a long lag. Also, interest rates are powerfully affected by general economic conditions. If the economy is growing slowly, interest rates will tend to be low because business demand for investment capital will be low. A pickup in economic growth, therefore, will tend to raise rates.

Keep in mind that businesses will not borrow unless they can earn a rate of profit greater than the interest rate. Thus the low level of business borrowing, which has helped keep interest rates down, is partly due to the low level of profit. Low profits are due to slow growth, which means that faster growth and higher profits -- two things everyone wants -- necessarily lead to higher interest rates.

The Bush administration argues that improving prospects for growth are behind the recent interest rate rise, a view supported by private economists, as well. If that is true, then rising rates -- as painful as they may be for bondholders and those seeking mortgages -- are a good thing. It means that businesses perceive better profits down the road and are borrowing more to take advantage of them.