The hot topic in monetary economics today (hah, if it’s not an oxymoron to say these terms together!) is whither interest rates. The Fed in its recent statement said the risk is balanced (the debunked notion of a tradeoff between unemployment and rising consumer prices should have been tossed on the ash heap of history in the 1970’s). The gold community certainly expects rapidly rising prices, and hence gold to go up, of course.

Will interest rates rise? We don’t think it’s so obvious. Before we discuss this, we want to make a few observations. Rates have been falling for well over three decades. During that time, there have been many corrections (i.e. countertrend moves, where rates rose a bit before falling even further). Each of those corrections was viewed by many at the time as a trend change.

They had good reason to think so (if the mainstream theory can be called good reasoning). Armed with the Quantity Theory of Money, they thought that rising quantity of dollars causes rising prices. And as all know, rising prices cause rising inflation expectations. And if people expect inflation to rise, they will demand higher interest rates to compensate them for it.

The quantity of dollars certainly rose during all those years (with some little dips along the way). Yet the rate of increase of prices slowed. Nowadays, the Fed is struggling to get a 2% increase and that’s with all the “help” they get from tax and regulatory policies, which drive up costs to consumers but has nothing to do with monetary policy. Nevertheless, interest rates fell. And fell and fell.

Why Have Interest Rates Been Falling?

It seems obvious that if one wishes to say that a trend has changed, after enduring for well over three decades, one needs to explain why. The Question of the Day is: what has suddenly happened? The quantity of dollars is going to rise? Been there done that, got the falling interest T-shirt. Prices are going to rise? Maybe.

For extra credit, no scratch that, to get any credit your answer should include an explanation of why the rate has been falling for so long. Is this too much to ask? Your explanation should contain three parts:

Keith published his theory of interest and prices. To cut to the chase, interest falls when the rate is above the marginal productivity of the entrepreneur. That is, when the marginal entrepreneur earns a lower return on capital than he must pay for the credit to finance it.

It should be obvious that you cannot borrow at 10% to earn 8%. If this is happening to the true marginal entrepreneur, and not just to an isolated bad businessman, then the interest rate must fall. It must fall because business demand for credit is weak under such conditions. And if the rate rises, the demand gets even softer. Businesses who can repay their debts will do so, even if they must liquidate capital assets to do so. Certainly, new businesses will not enter the market if they see a negative spread between cost of capital and return on capital.