What Will Happen
to Interest Rates?

by Michael Walker

What will happen to interest rates? I have just returned from Washington, DC, where there is a debate raging about whether Alan Greenspan and the Federal Reserve Board should be raising or lowering interest rates. The central question is whether the US, and by extension the world economy, is inflating or deflating.

Now, you would have thought that this would be more or less obvious. Why don’t people just look at the inflation index. Up means inflation. Down means deflation. If there is inflation, raise interest rates, and if deflation is the game, then reduce them and let’s get on with it.

Of course, as you’ve already guessed, the problem is that people have been looking at the inflation index and they have different opinions. Inflation or deflation, so it seems, is in the eye of the beholder. There are, therefore, two camps emerging. One group is led by Jerry Jordan, the President of the Federal Reserve Bank of Cleveland and a member of the Federal Reserve Board’s Open Market Committee. He’s joined by Bill Poole, President of the Federal Reserve Bank of St. Louis, who is also a member of the committee.

Jordan (who is a frequent visitor to The Fraser Institute in Vancouver), and those who agree with him, believe that the supply of money has been growing too fast, that there is evidence of dangerous levels of inflation, and that the Fed should be tightening the monetary reins in order to stop the process. The evidence he cites is not provided by looking at the ordinary measures of inflation. He believes we are deceiving ourselves by including the increasing price of houses and consumer durables in our measurement of inflation, while ignoring the rapidly escalating price of other assets—in particular the ones that are traded on the major stock exchanges. Jordan looks at the record level of stock prices in North America, even with the recent adjustments, and concludes it is there that inflationary pressure is predominantly being reflected.

Then there are the others, like Bruce Bartlett of the National Center for Policy Analysis, who take a very different view. According to Bartlett, there are two good reasons for expanding the supply of money and lowering interest rates. The first is that there is ample evidence of deflation. The falling price of gold and other commodities in terms of US dollars indicates to him that there are too few dollars around. The solution? Expand the money supply and reduce interest rates.

The second reason relies on a view which, paradoxically, is due to Jerry Jordan. Some time ago, Jordan began to talk about the very large portion (up to 7 out of every 10 dollars) of the supply of US greenbacks which actually circulate outside the United States. The US dollar has become the currency franca of many of the world’s transitional economies and the backbone of many other currencies, including the Hong Kong dollar, the Argentine peso, and the currencies of the Baltic states.

Bartlett takes this view of Jordan’s to what may or may not be a logical conclusion, namely, that the US money supply is greatly overestimated by the figures published by the Federal Reserve Board. Once the money supply is adjusted for all the foreign circulation, according to Bartlett, the actual rate of growth is too slow to sustain economic growth. Therefore, the Fed should speed up money supply growth.

Of course, as is often the case, there are merits in both these views. And weaknesses also.

My own view is that the Federal Reserve Board’s Alan Greenspan will take a cautious approach, and for the foreseeable future will do nothing. If he moves soon, however, I think that he will be inclined to side with Bruce Bartlett rather than Jerry Jordan. The reason has less to do with the merits of their arguments than the potential consequences of error. If Jordan is correct and rates are nevertheless dropped, the consequences will eventually be a higher rate of inflation as money supply is allowed to grow too quickly. This would be uncomfortable—but not catastrophic—particularly in light of the bearish sentiment currently prevailing in asset markets.

If Bartlett is correct and there is a major deflation under way, a liquidity crunch could have horrible consequences for the world economy. And the spectre of the huge mistake that the Fed made in the Great Depression when it let the money supply shrink while a major world-wide deflation was in process still hangs over its head. Greenspan will not want to be remembered as the Chairman who repeated that error.

So, I’d bet that there will be no increase in US interest rates. That means Canadian hikes are also unlikely, assuming the currency doesn’t collapse further. The most likely course is no change for now.

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Last Modified: Wednesday, October 20, 1999.