Why Interest Rates Are Likely To Stay Low

by: Larry MacDonald

The imperative to shore up the banking system explains why predictions of Fed rate hikes may be off the mark – even if inflation continues to rise. Financial stability is a higher priority, so rates need to be held low to allow hard-hit banks to recapitalize (as noted in my previous post).

Besides, there is no need for higher Fed rates if inflation is going to moderate on its own. Some may think negative real interest rates are a stimulative monetary policy bound to accelerate inflation — but policy remains restrictive, according to Sherri Cooper, chief economist at the Bank of Montreal.

That’s because of the credit crunch. As the Fed’s April survey of loan officers showed, there “has been a record level of tightening” in U.S. credit standards. Going by my very rough calculations, this puts the effective Fed rate closer to the 3.75% rate recommended by the Taylor Rule.

Lastly, for inflation to enter a runaway phase, wages need to begin rising too. However, workers don’t have much bargaining power when job losses are piling up. The chances of a wage-price spiral commencing appear to be rather small.