The Long View – Rates, GDP & Challenges

There has been much debate about the current low levels of interest rates in the economy today. The primary argument is that the “30-year bull market in bonds”, due to consistently falling interest rates, must be near its end.

Of course, this debate has devastated the “bond bears” who have consistently been frustrated by lower interest rates despite their annual predictions to the contrary. However, just because interest rates are currently low, does this necessarily mean that they must rise?

The chart below shows a VERY long view of interest rates (equivalent rates to the Federal Funds Rate and 10-year Treasury) back to 1854.

While there is much data contained in the chart above, there are a couple of important points to consider in this debate. The first is that interest rates are a function of the general trend of economic growth and inflation. Stronger rates of growth and inflation allow for higher borrowing costs to be charged within the economy. As shown, interest rates have risen during three previous periods in history; during the economic/inflationary spike in early 1860’s, again just prior to 1920 and during the prolonged manufacturing cycle in the 1950-60’s following the end of WWII. Secondly, interest rates tend to fall for very extended periods.

However, notice that while interest rates fell during the depression era economic growth and inflationary pressures remained robust. This was due to the very lopsided nature of the economy at that time; the wealthy prospered while the middle class suffered, which did not allow money to flow through the system (monetary velocity).

Currently, the economy is once again bifurcated. The upper 10% of the economy is doing well while the lower 90% remain affected by high levels of joblessness, stagnant wage growth and a low demand for credit. For only the second time in history, short-term rates are at zero and monetary velocity is non-existent.

The difference is that during the “Great Depression” economic growth and inflationary pressures were at some of the highest levels in history, while today the economy struggles along at a 2% growth rate with inflationary pressures that detract from consumptive spending.

Let’s look at the fall of interest rates since the 1980’s in a slightly different manner.