How Interest Rates Work

While it is no doubt presumptuous to advise Nobel Prize winners, It seems to me that in an additional response to Paul Krugman's blog post, a little basic economics is called for. 

The level of interest rates sends basic signals to investors, and if they are kept artificially low the signals are false ones. That rate affects all prices and all investment decisions. If an investor is considering an investment, the Return On Investment, ROI, is a crucial part of the investment process. Let's say that the interest rate is 5%. If the investor estimates that an investment will generate a return of 4%, the investment will not be made. Even at a return for the investment at 6%, this might not be enough margin for an investor to decide to invest. 

Here Are Some Effects of Lower Interest RatesWhy then is a lower rate of interest bad? Doesn't that mean that more investments are made? Yes, lower value investments are made for the "big boys." They are the ones that can borrow money at 2 to 3%.  But there is a huge risk because of the mismatch that exists in modern investment between the maturity of a loan and the maturity of an investment. When an investment loan rolls over and needs to be renewed, the borrower will pay what ever the current interest rate is. But the investment is not necessarily something that can be sold quickly. So a borrower may suddenly be paying 6% for an investment that only pays 4%. Unless the investor has other income that can be used for the bank payment, foreclosure is in the future.  

The result will be hugely deflationary. 

Will interest rates rise? Interest rates are not just low for recent times, they are not just low in living memory, they are the lowest they have even been in the history of the world. 

A rise in interest rates is inevitable. 

So if this rise in interest rates is deflationary, why am I predicting 50% inflation spread over 5 to 7 years? The reason is that the Federal Reserve will not allow the market to work and will re-inflate as the negative consequences of higher interest rates happen. In other words the Federal Reserve will over compensate. Then after the inflation occurs, the Federal Reserve will deflate again to prevent hyperinflation. 

We will have a very rocky time for the rest of the decade and a good part of the next decade.  

Get Ready.