TFTB – Likely Rates Will Continue To Fall

As I sat on the beach this morning watching my kids play in crystal blue oceanic waters, my thoughts drifted to the ongoing confusion regarding interest rates. The central premise is as follows:

“How can rates be falling when it is so evident that economic growth has finally taken hold?”

It is an interesting question that I thought deserved a deeper discussion.

There is scant evidence that economic growth has gained enough momentum to break out of the roughly 2% annual growth rate that has existed since the turn of the century. The latest reports on factory orders, inventory builds and employment expectations have been less than exuberant. Furthermore, as shown below, the annualized rate of growth in real, inflation-adjusted, final sales in the economy are at levels normally associated with recessions rather than economic expansions.

 

The same goes with gross domestic incomes which plunged in the first quarter to levels, as with final sales above, normally only witnessed during economic recessions.

 

While I am not suggesting that economy has plunged into a recession and that the “end of the world is nigh,” I am suggesting that there is more to the interest rate story than meets the eye.

As I discussed earlier this week, interest rates, inflation and economic growth are all very closely related as shown below.

 

Since the level of interest rates are a function of demand by borrowers, it is only logical that it would take a much stronger level of economic growth, which would lead to rising inflationary pressures, to substantially increase the level of borrowing costs due to rising demand. When taken in this context, the incoming economic data hardly supports the unanimous belief by economists that interest rates and inflation are set to surge higher in the months ahead.

Since the end of the financial crisis, the Federal Reserve has been intervening in the financial system by artificially suppressing interest rates and injecting liquidity to boost asset prices. The belief, as stated by Ben Bernanke in the summer of 2010, was that rising asset prices would boost consumer confidence and fuel an ongoing economic recovery.