Parsing interest rates
Long-term interest rates have risen substantially over the past few months. But what does that mean? Is it the burden of vast government borrowing, as the deficit hawks claim? Or is it actually a good sign, an indicator of greater confidence?
But there’s another route. One of my favorite Jeff Frankel papers was his piece with Charles Engel on short-term interest rate movements. Back in the 80s, people still paid a lot of attention to monetary aggregates. When M1 came in above expected, interest rates tended to rise. Monetarists said, “See — the market is afraid of inflation.” Others said, “See — the market is afraid that the monetarists at the Fed will raise rates to keep to the monetary target.” Who was right?
Engel and Frankel pointed out that events in other markets — specifically, the foreign exchange market — could resolve this dispute. If it was inflation fear, a bump in the money supply should go along with a weaker dollar; if it was fear of tightening, it should go along with a stronger dollar. And the evidence clearly pointed to the fear of tightening story.
So what about now? Foreign exchange is not as useful, because we’re all sort of in the same boat. However, commodity prices could play the same role. If we’re seeing rising rates because government borrowing is crowding out private borrowing, commodity prices should go down: holding inventories becomes more expensive. If we’re seeing increased optimism, commodity prices should go up, anticipating a stronger future.
In fact, commodity prices have gone up. It’s not a slam-dunk, because commodities have bubbles, too. But it’s one more piece of evidence against crowding out."