Don’t Remove the Canapes Yet -- the Low-Interest-Rate Party Isn’t Over

An interesting new book by Robert Sullivan suggests that rats live in a perpetual state of panic. If so, they are not that different from traders in financial markets, whose most recent outbreak of anxiety centers on the overdue realization that, as the Economist magazine had it, “the era of cheap money is over.”

So are they right? Are we really about to see a dramatic reversal of interest rates? In fact, no. No party lasts forever, and rates can’t stay as low as they are indefinitely, but there is no reason to believe rates will rise as fast as the current panic suggests.

Money today is stunningly, compellingly cheap. As recently as a year ago, financial markets were gripped by a wave of concern regarding deflation. The theory was that falling oil prices, a soft economy and the presence of a billion Chinese ready to work for beans guaranteed ever- declining prices.

To avoid this catastrophic outcome -- who would ever buy anything today if everything was going to be cheaper tomorrow? -- the Fed lowered interest rates to levels never seen by most of us, levels like today’s meager 1%.

But the expectations of a slow, deflationary economy ceased overnight -- and it was a specific night, April 2, 2004. Because the next morning, the Bureau of Labor Statistics announced that the economy had created 308,000 new jobs in March. (Leave aside a few issues, such as 25% of the increase coming from the quirky construction sector and the fact that total hours worked in the economy actually went down, hardly a sign of a bottle-rocket labor market.) News of this sudden burst of employment, combined with some recent higher-than-expected inflation numbers and good reports about retail sales and factory orders, sent the financial markets into a tizzy. The economy was about to surge, inflation was back and the Fed was about to pull back the throttle and run the interest rate machine in reverse.

The vehemence of the markets’ sudden apostasy, like that of any other penitent, reflects to some extent the absurdity of earlier beliefs. Lulled to sleep by the deflationists and the slow-growth crowd, the markets had somehow chosen not to see that interest rates could not stay at 1% forever. At some point, rates will have to rise substantially from their current levels; to think otherwise is to believe the economy will never again grow. Markets consigned this inevitability to the distant future, but as they say in football, the future is now.

So the question is, when will the Fed begin its long march back to interest rate normalcy? Certainly, with rates as low as they are, they have a long way to go. But that doesn’t mean they need to start soon.

The March employment report aside, total employment in the economy has grown by only about two-thirds of 1% -- by 780,000 jobs out of a labor force of 120 million.

A good comparison point is what happened in the 1990s when total employment had grown by only two-thirds of 1%, and interest rates, like today’s, offered no premium over inflation.

It wasn’t until total employment grew by a full 4% in the recovery later in the ‘90s before the Fed felt obliged to put interest rates on their inevitable journey to normal levels. Using that calculation, the economy could produce monthly job gains of 300,000 for months if not a year before the Fed would take action.

But the odds of that happening are slim. Even though the economy is growing, employment will have to work hard to catch up. The disconnect between the two is productivity -- our ability to produce larger amounts of stuff with the same number of people. Productivity always grows dramatically in the first few quarters of a recovery, as the economy bounces back from its doldrums and factories and offices go back to work. But after about six quarters of recovery, this “bounce-back” typically peters out. We are now a year past that point and yet productivity continues its torrid pace. To be sure, the Fed has many balls to juggle when determining rates. Inflation may have risen in recent months, but with employment low, productivity high and imports abundant, it’s hard to imagine the prices of goods and services rising.

The fly in the ointment might be timing. If the Fed doesn’t raise rates at its next opportunity this June, it will have to act later this year, in the shadow of the presidential election. It seems unlikely that Greenspan, who played off the Bush administration’s sheet music during the tax cut debate, will want to plunk a discordant note during the campaign. So a preemptive hike in June can’t be dismissed. But so long as productivity continues to race ahead, the Fed can bide its time. The party may be winding down, but it’s not yet over.