Monday, February 22, 2010

Money Growth and Interest Rates in the US

The graph above (click on it to magnify) from the latest edition of Mishkin's Money and Banking textbook illustrates the short and long-term effects of monetary expansions on US interest rates (liquidity preference theory) since 1950.

The graph shows how the fast monetary expansion following the financial crisis, as expected, temporarily drove down interest rates. Nonetheless, if the past serves as a guide, this liquidity effect will probably sooner rather than later be replaced by income, price-level and expected-inflation effects, at which point interest rates will have to rise. Given the current policy of easy money, the only way interest rates could remain so low for a longer-than-usual period is if some strange financial innovation continuously brings down the velocity of money. I'm not betting on the latter though (it wouldn't be a beautiful scenario anyway). My guess is that the Fed will be forced (and forced is the word) to raise rates soon, once money starts to move around (in other words, I have a hard time believing that Americans can fully emulate Japanese household behavior and their government's policy mistakes).

In this case, it'll be interesting to see how rising nominal interest rates will interact with the financing of the huge budget deficits that we've been experiencing for years. On one hand, the need to tighten the monetary policy stance will conflict with the expansionary fiscal policy of the administration, reducing its access to debt financing. On the other hand, it will impose a much more significant debt servicing cost on the US Treasury, meaning that payment of interests on preexisting debt will also conflict with the administration's spending priorities. Both effects could lead to a new wave of populist rambling against the Fed and calls for an inflationary policy, feeding monetary disarray. So the question is: is this country heading towards fiscal and monetary chaos banana republic style?

1 comment:

Blog do Adolfo said...

Great post Pedro.

Here in Brazil I am betting in a new wave of inflation too.

Adolfo