December 16, 2021
By Scott Wohlers
Everyone who has any study of economics understands that too much money chasing a given supply of goods causes prices to rise. Rising prices (inflation) cause interest rates to go higher too. After all, why would investors lend money at rates less than the inflation rate? That would be tantamount to giving someone the use of your money and accepting less in buying power when it is returned.
Of course, our financial system is far more complex than this example, but these are the basic mechanisms. So why do we have low interest rates and rising inflation? Part of the answer may lie in the fact that the Federal Reserve has pumped so much money (liquidity) into our system that all of it is not looking for goods to purchase. Much of it may be saved. Banks have more money deposited than there is loan demand. They, along with many other entities and individuals, seek a return on these balances. So, they buy liquid Treasury bonds or others to put some of it to work. What does too much money chasing a limited supply of bonds do? Of course, it forces prices higher and yields lower.
The paradox is that with the injection of too much liquidity into our financial system, rates go down, even as inflation increases. Certainly, there may be other factors in setting interest rates such as future economic growth expectations, fears of ongoing crises, and the desire for some stability in outcomes. However, the current paradox seems to owe a lot to excess liquidity. The Federal Reserve is now in the process of reducing and eventually eliminating this excess. In time, interest rates should rise as supply and demand come into better balance. Then, the economic relationships we have observed in the past operate as expected. Avoid investing in longer term bonds, rates will go higher; stay steady my friends.
The Lonely Bull
