Why Interest Rates Matter
This article is the first of a series discussing why interest rates are important. The focus of this article is the philosophical place of interest rates for resource allocation in an economy.
One of the central aims of any economic system is to allocate scarce resources between its members. To solve these allocation problems, a large number of economic systems have spawned throughout history ranging from simple tribal systems with relatively equal distribution of subsistence resources to large scale systems such as capitalism and communism. The goal of all these systems is to balance often competing goals of allocating resources in a efficient, stable, and equitable manner. In most contexts, the allocation problem is framed in terms of distribution across the space of people in the current time, such as deciding between guns and butter or moving a product worth $1 in one location vs $2 in a different location. As if this was not difficult enough, the arguably much more difficult problem is allocation of resources across time. How much should any one individual consume today versus tomorrow? 5 years from now? This distribution of resources across time is essential to ensure capital for mundane activities like storing food for the next season to funding the next energy revolution. Analogous to the flow of water down a river, capital flows towards prices that offer optimal returns across today and the future in the form of trades and loans made for different maturities. These returns form the grid of interest rates for different maturities and risks for a given economy.
The problem of optimal allocation across time is not new and has been faced by societies since antiquity. For a pastoral society the main store of wealth and capital is the cow. Beyond religion, the Indian admonition against eating beef is an ancient form of capital preservation by religious diktat. During times of famine the temptation is high to slaughter cattle today but this will spell doom later as there is no capital, i.e. breeding animals left to rebuild the herd. Such economies do not have access to complex pricing mechanisms, and besides, prices mean little as famine hits so a religious order is often the most effective in such situations.
Moving forward in time, one of the most stable economic systems mankind has stumbled upon is feudalism. The system itself may be terrible for most but it’s record of stability is unmatched with thousands of years of existence in most parts of the world, including most countries which were nominally monarchies but economic power rested with local lords. The feudal system deals with time allocation of resources also in a very simple way with the allocation of goods and services in the future largely equal to the allocations in the present. Most economic entities in a feudal system perform the same action their previous generation did such as a blacksmith following his father’s profession, which works well as long as population growth is stable and economic growth is stagnant. In Europe, it took the upheaval of labor shortages arising from the Black Death to break down feudal systems.
Finally another alternative example of time allocation of resources was the USSR where most of the current consumer was pushed forward to the future and replaced with military goods. Given the low productivity of most military spending, there was little capital leftover for ideas to drive the future sending the economy in an increasingly moribund trap. The economic system would always have difficulty competing with more efficient capital deployment mechanisms such as those in the USA. Marxist theory has not yet produced a great example of efficient resource allocation over time since centralized decision making is especially poor at allocating capital to resources and ideas in the future.
Free market systems allocate resources using prices with relative prices informing on the excess supply or demand of the particular resource. Of course, capital, a.k.a money is the ultimate resource as it allows purchase of most other available resources. Prices are the most efficient processors of economic information we know of, as long as the underlying assumptions of free markets such as competition are not violated (this assumption is often glossed over by blind adherents of free markets). While the range of goods and services in a modern economy can be incredibly complex, the three key attributes of most products are the location, the quality, and the time, referring to when the product is to be received. Location and quality are spatial attributes and current prices influence their allocation. If the price of an avocado is 25 cents per fruit in Mexico and the same fruit is $2 in NYC, the prices will converge unto the cost of transportation and logistics. Similar arguments apply to quality.
The time factor is less straightforward but in principle, an avocado will have a price for today, tomorrow, 1 year from now, and so on. If we take the case of 1 year from now, the $2 avocado today may be worth $3 a year from now. What does that tell us? This 1 year ahead of price is the price of being indifferent between taking the fruit today, storing for a year in a fridge with all the costs associated with it such as electricity, and then selling the same fruit a year from now (we are of course making the simplifying assumption that avocados are not perishable but the underlying concept remains). The cost of electricity and storage is one set of costs which is relatively simple to calculate. The more nebulous concept is opportunity cost, which is the cost of making this particular investment versus all others, or in simpler terms, the cost of tying up money in this investment instead of leaving it in the bank. The interest rate quantifies this opportunity cost of tying up money for a decision over a time period.
An economy is a network of decision paths across time to deploy resources. The interest rate is the opportunity cost quantified for making a given decision versus all others. The simplest decision, economically, is leaving money in an assumed risk-free account. This interest rate, the so called risk-free rate forms the bedrock of comparison of all other economic decisions — does your investment offer returns above leaving money in the bank adjusted for its risks? This constant competition with the risk free rate and other comparable interest rates drives the ebb and flow of economic activity. Raise rates too high and most investments suddenly become underwater. Leave rates too low and money eventually finds its way into increasingly more speculative activity as over the last few years. For example, if you borrow money from a bank to buy a rental property, for a given level of rent, a higher mortgage rate will make the investment less attractive and vice versa for a lower rate. Staying with the bank example, if interest rates stay low for sustained period of time, more and more people will show up to borrow from the bank to buy properties in town. This will raise prices of properties in the town while the increased demand for loans will prompt the bank to charge a higher interest rate both to raise profits and to cushion against too many people defaulting later. A high interest rate can partly reflect high current growth coinciding with strong demand for borrowing and this same high interest sets the stage for a slowdown in the future as new investments become unprofitable. Conversely, a low interest rate conveys low expectations of growth and low demand for borrowing in the current time while also setting the stage for future growth. The mortgage rate in this example is one of hundreds of interest rates being derived from a baseline ‘risk free’ rate with the difference reflecting the particular risks faced by this type of investment. The loan on a rental property will have a different interest rate versus the interest rate to borrow to build a factory reflecting different risks in each business. The quantification of opportunity cost that interest rates reflect is composed of the value of time the capital is tied up versus leaving it in a safe bank account along with the estimated risk of losses faced by the individual investment.
Finally, there is another type of risk lurking here. If you lend $100 for 10 years, with the promise to receive $110 at that point, there is a risk prices of all goods and services could rise sharply by then leaving your $110 worth far less. Even if you get paid in full and on time, if the price of everything has doubled, it would have been far better to just spend the $100 today and the opportunity cost of not spending today needs to be much higher. This would drive up the interest rate needed to compensate for tying up money. The common term for prices rising is inflation and was a big reason why interest rates were close to 15% in the early 1980s while today linger at closer to 3%. In emerging markets where inflation is a much higher (the reasons will be the topic for another post), interest rates can easily be 10–20% or higher for even regular bank accounts. Of course, in our example, the knowledge of prices rising was not evident until after the money was locked in so expected inflation is incorporated in the interest rate.
Given the power of interest rates to modulate economic activity, understanding what interest rates are at different maturities conveys a significant amount of information. The “surface” of interest rates reflecting time and investment risk compress information about the economy, expected inflation, and investment risks. A simplified version of this is the yield curve of the risk-free rates which shows interest rates for different maturities. Risk-free rates here specifically mean Treasury rates, which are the rate at which the US Federal Government borrows at. In addition to the level of interest rates along the yield curve, the shape is also important. A “steep” yield curve where longer maturity rates are higher than short term rates reflects higher expected growth and inflation in the future than today. Similarly, an “inverted” yield curve reflects future depressed growth and inflation compared to today and so often heralds a recession, such as the inversion in 2007 just before the crash. After the 2008 crash, current growth prospects were subdued but future growth was being added in. The resulting steepening of the yield curve signaled a return to riskier assets such as stocks which staged a sharp rally for the next few years. Indeed, an active thread of discussion in the financial press recently has focused on a possible inversion of the US yield curve, which may indicate an impending recession and bad times for the lofty stock market. Although there are a number of nuances to these interpretations, the yield curve is one of the best ways to infer the state of the economy without waiting for economic data which arrives far too late.
Beyond the philosophical reasons why interest rates matter for an economy, it is essential to use the information being conveyed by them to make more informed decisions about personal investments whether they are housing or stocks.
