Friday, June 5, 2009

Higher interest rates beckon?

The NYT reports that as the world economy contracts and governments across the world indulge in aggressive stimulus spending, their public debts and fiscal deficits are mounting and will continue to do so for atleast the coming couple of years.

A simultaneous across the world demand for more borrowings by governments will at some time have to start straining the supply. And if that happens, the cascading effect on interest rates will follow. US Fed Chairman Ben Bernanke, in his testimony to the House, expressed concern about the rising government debt (the CBO has estimated it to rise to 65% of GDP at the end of fiscal 2010, from 41% at the end of fiscal 2008)and fiscal deficit (estimated to be $1.8 trillion this year) burden and the need to restore fiscal balance, so as to maintain the confidence of the financial markets and thereby manage expectations.

And the trends with the longer term government bonds, a reflection of the expectations about future rates, are not encouraging. As the report indicates, since the end of 2008, the yield on the benchmark 10-year US Treasury note has increased, at its sharpest move upwards in 15 years, to 3.54% from 2%. Over the same period, the yield on German 10-year bonds has risen to 3.57% from 2.93%, and British bond yields have increased to 3.78% from 3.41%. The yield difference between two and ten year Treasury Bonds has been on an increasing trend since early this year, pointing towards possibility of higher rates in the medium term.

Further, with China, the largest single buyer of US Treasuries, starting to diversify away from US dollar assets and in particular longer term bonds, the day is not far ahead when the "global savings glut" would become history. This is also likely to add to the list of supply side constraints on the availability of savings.

The other side of the interest rate debate is inflation. Conservative economists, led by those from the University of Chicago, have argued that the massive deficits carry the seeds of runaway inflation and the possibility of high interest rates to contain it. Niall Ferguson and John Taylor have been vociferous proponents of the view that the rising debts are bound to unleash inflationary pressures.

However, in light of the declining consumer prices and stagnant wages, Paul Krugman feels that deflation and not inflation is the immediate danger. The excess credit pumped into the economy by way of quantitative easing is finding its way back into the government through investments in Treasuries by a risk-averse banking system. Martin Wolf sees little concern in the rising bond rates and sees it as a "desirable normalisation after a panic" as investors who rushed into the dollar and government bonds are now rushing out again.

On the contrary, he writes that the rebound in bond yields may be a signal that the threat of deflation may have receded, "after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone."

Both inflationary pressures and interest rates will remain under check as long as the supply of savings exceeds the demand for investible funds by businesses and the willingness of banks to lend to those borrowers. The weak economic environment and the aversion to risk among bankers means that private spending will remain anemic and muted. Government spending will only be absorbing some of the locked up savings and not competing with private spending to unleash inflationary pressures.

In the circumstances, it will boil down to how the massive debts are unwound (repaid) and inflationary pressures are managed as the economy starts its recovery. An L-shaped recovery can be of help in a slow release of credit and expansion of private spending and also give the government enough time to manage its debt repayment burdens. The prolonged slow period of economic growth may also partially explain why Japan has not had inflationary spirals despite its massive public debt and credit expansion during its lost decade in the nineties.

Update 1
Freakonomics has a post by Eric Zitzewitz about the Krugman-Ferguson debate on what has caused the recent hardening of interest rates. He agrees with Krugman that the recent increases in bond yields is due to easing of fears about deflation, but that fears about inflation may pose dangers in the coming days.

Update 2
Arthur Laffer feels that the dramatic increase in monetary base over the past year is harbinger of high inflation in the years ahead. Paul Krugman, in turn uses data from monetary expansion of Japan in the nineties and US in the thirties to show how deflation results. David Altig and Mark Thoma too join the debate. Krugman points to Brad Setser who finds data to prove that US is actually borrowing less from foreigners than before and that net borrowings are down.

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