by Archie M. Richards, Jr., CFP^®
February 28, 2005

Short-term interest rates have risen lately. But long-term rates, which are paid by governments and corporations on money they borrow for years, have been falling for 25 years. Why? And what about the future?

The answers rest on the following:

• A general rise in prices (inflation) occurs when the money supply grows faster than the goods and services available to buy.
• As inflation rises, creditors demand higher interest rates to compensate for the loss of buying power of their money.

Note the two parts of the first statement:

1. money supply and
2. goods and services available to buy. Short-term interest rates are related mostly to the money supply. Long-term interest rates are related mostly to the availability of goods and services.

The Federal Reserve Bank produces most of our money and therefore has pretty good control of short-term rates. But the Fed does not produce goods and services and therefore has little control over long-term rates.

About 90 percent of our money supply consists of bank deposits. (The other 10 percent, cash and coin, is minted by the Treasury Department.)

To increase bank deposits, the Fed buys Treasury bonds, paying for them by writing numbers in the bank accounts of the former Treasury owners. These numbers are new money, available for spending as the former owners please.

To reduce bank deposits, the Fed sells Treasuries it bought previously. The Treasuries are passed out to the public. The money paying for them comes to the Fed and disappears.

The Fed buys more Treasuries than it sells, causing the money supply generally to increase. To enable the economy to grow, the money supply must do the same.

In the last few years, the Fed has flooded the economy with new money in an effort to arrest the harm done by the 2001 recession. With money plentiful and with prices not rising rapidly, short-term interest rates fell to very low levels.

Now that the economy is growing smartly, the Fed is limiting the growth of money to prevent a general rise in prices from getting out of control. It's doing a good job of keeping the amount of money in balance with the current availability of goods and services. But limiting the money supply has caused short-term rates to rise. They will continue doing so until the Fed feels that, despite rapid economic growth, inflation is not a problem.

Now back to our original statement: Inflation results when the money supply grows faster than the goods and services available to buy.

Unlike short-term rates, long-term interest rates are determined mostly by how many goods and services creditors expect to be available in the future. Long-term rates have generally fallen because creditors have expected the amount of goods and services to grow rapidly, keeping inflation well under control.

I'm optimistic about the future availability of goods and services. Business operates within a framework created by economic policies. Those policies are improving rapidly. Gone are the pernicious policies that created the Great Depression of the 1930s, including high tariffs, income tax rates of 70 percent, a sharp cut in the money supply, labor costs kept high, excise taxes on every-day items bought by the poor, and chain stores prevented from passing the lower costs from big-volume purchases to customers.

Gone as well are the damaging policies of the 1970s, including continued high income tax rates with capital gains rates of 70 percent, heavy-handed trucking and airline regulations, and general wage and price controls, all of which created 15 years of inflation and slow growth.

Current economic policies still do plenty of damage - especially today's onerous regulations. But overall, policies are improving all over the world. I expect them to continue doing so.

Moreover, incredible new developments in high-technology approach, bringing even greater improvements in productivity. The result? A flood of goods and services will outpace the money supply. Inflation will disappear, and long-term interest rates will fall.

Long-term rates have been falling for a long time. Except for normal blips, this trend will not reverse, as many people expect them to. Long-term rates will continue down. And eventually, short-term rates will fall as well.

Good times are coming. Very good times.