Where Are Interest Rates Headed

According to the Federal Reserve, economists assume interest rates will move toward equilibrium or a ‘natural’ real rate of interest that takes into account inflation over the long term.

The idea of a natural rate of interest was first introduced by Swedish economist Knut Wicksell.  Recognized as an economist’s economist in the late 1800s and early 1900s, Wicksell is known for his macroeconomic text Interest and Prices which noted the difference between the real rate of return on capital (aka: the natural rate of interest) and the market rate of interest (aka: the rate borrowers pay). According to The Economist:

“If the financial rate is below the natural rate, businesses can reap unlimited profits by borrowing as much as they can and plowing it into high-returning projects. Eventually, though, all that additional spending pushes up prices, money and credit, and, eventually, financial interest rates.

Wicksell saw financial rates as those set by banks competing to make loans. That job is now performed by central banks. They still think in Wicksellian terms: the natural rate prevails when the economy is at full employment. Set the policy rate above the natural rate and the economy tips into depression. Set it below, and inflation results – or, some worry, speculative credit booms.”

So, where are interest rates headed? Apparently, they’re going to move higher. According to the Federal Reserve’s September 2013 economic projections, the federal funds rate (the rate at which banks lend to each other overnight) is expected to reach 2 percent by the end of 2016. Currently, it is at 0.25 percent. (The Fed also expects the United States will be close to full employment at that time with the unemployment rate nearing its long-term average of 5.2 to 5.8 percent.)

Weekly Focus – Think About It

“It has always seemed strange to me… the things we admire in men, kindness and generosity, openness, honesty, understanding and feeling, are the concomitants of failure in our system. And those traits we detest, sharpness, greed, acquisitiveness, meanness, egotism and self-interest, are the traits of success. And, while men admire the quality of the first, they love the produce of the second.”

John Steinbeck, Pulitzer and Nobel Prize-winning American author

Best regards,

Jonathan K. DeYoe

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Sources:

http://www.investopedia.com/terms/c/contrarian.asp

http://www.aaii.com/sentimentsurvey

http://online.barrons.com/article/SB50001424053111904897104579149482465343894.html?mod=googlenews_barrons (Or go to http://peakclassic.peakadvisoralliance.com/app/webroot/custom/editor/10-28-13_Barrons-The_Rally_That_Just_Wont_Quit.pdf)

http://www.frbsf.org/economic-research/publications/economic-letter/2003/october/the-natural-rate-of-interest/

http://www.econlib.org/library/Enc/bios/Wicksell.html

http://www.economist.com/news/finance-and-economics/21588354-central-banks-ignore-century-old-observation-their-peril-natural

http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130918.pdf

http://www.bankrate.com/rates/interest-rates/prime-rate.aspx

http://www.brainyquote.com/quotes/authors/j/john_steinbeck.html#FU0ZPZMKKk5pwDOJ.99

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