Interest Rates Cannot Go Up Far, Or Hold for Long

Consumer prices have been on a tear, since early last year. Right now, the Consumer Price Index (CPI) is rising at more than 8% per year.

Source: St Louis Federal Reserve

Conventional thinking calls for higher interest rates. It makes this call via two channels. One is its policy prescription. The other is a theory of how market participants will behave.

There is no such thing as a good central bank policy. All central bank actions inflict harm on the people. However, if one’s sole focus were consumer prices, then one should want lower interest rates rather than higher. A falling interest rate is a rising incentive to borrow more to produce more, at lower margins. We have discussed this elsewhere, and so will not repeat our argument here.

The Bond Market is Different

Today, our focus is how market participants respond. When market participants act en masse, they are a much larger force than any central bank (just as every Governor of a Banco De Republica de Banana, to the Swiss National Bank, has learned to their chagrin).

The theory is simple. If prices go up 1%, then the dollar has lost about 1%. So why should market participants buy bonds that don’t earn more than the dollar is losing?

We see something that looks like this behavior in other markets. For example, pipe manufacturers buy copper and sell pipe. If the price of copper goes too high, then they can’t make any money. So they stop buying copper (alternatively, they could try raising their prices, but home builders will increasingly stop buying copper pipe and switch to plastic).