Quickly, among the reasons we anticipate a multi-year US dollar bull market in the making is interest rate differentials. While the difference between interest rates in the US may not close significant ground versus all major central banks, we believe the current US yield disadvantage to the UK and Eurozone will narrow; and the advantage of US rates over Japanese rates will widen.

Now, the market was tuned in yesterday to hear Fed Chief Bernanke’s testimony. And the takeaway, as headlines after Bernanke’s comments imply, is that the Fed will be keeping interest rates low for longer. In other words, those betting on a narrowing interest rate disadvantage for the US might have to rethink this idea.

Sure, that’s a valid expectation (or at least a typical one.) But let’s leave the market reaction aside for a moment ... and try to touch on the economics of the interest rate decision and its consequences.

John Maynard Keynes argued that higher interest rates would reduce the rate of saving. That is, the higher cost of borrowing to invest (save) would more than offset the attraction of higher expected income in the future as a result of higher interest rates.

But Henry Hazlitt, in his book The Failure of the “New Economics”, tries to bring light to the other half of the equation that he believes Keynes so blindly fails to address. Hazlitt makes the point that an increase in the cost of anything will repel demand to a degree. That is unless the characteristics of demand have shifted. In other words, growing demand for something may be the cause of rising prices (cost) for that something. But in this instance explained by Hazlitt, rising cost resultant of rising demand will not necessarily have the same impact on demand as some arbitrary increase in cost would.

He applies this to interest rates, saying that the higher cost of borrowing resultant of higher demand will not necessary decrease the amount of borrowing.

“Indeed, if the rise in interest rates is not sufficient to offset the rise in the demand schedule for investment, more capital will be demanded at the higher interest rate than at the previous lower one. And as a rise in interest rates may encourage saving and lending, this rise in interest rates may be precisely what is needed to bring forth more loanable funds to meet the increased demand."

“What Keynes illustrates ... is his persistent fallacy of considering the effects of interest rates only on borrowers and not on lenders, the effect of wage-rates only on workers’ incomes and never on entrepreneurs’ costs. It is this willful blindness to the two-sidedness of every transaction – this concentration on the incentives to borrowing and the obliviousness of those to lending, on the incentives of the buyer and not the seller, of the Consumer and not of the Producer, this terrific to-do about the propensity to consume while the propensity to work is taken for granted or forgotten – it is this one-eyed vision that constitutes the Keynesian “revolution.”

The perpetually low interest rate trajectory as dictated by the Federal Reserve is meant to help the economy along amidst a horrible employment situation. But is Bernanke et al guilty of drinking Keynes’s cool-aid in secret? It seems as though their concern with reviving the US consumer is prohibiting their efforts at keeping credit markets efficient and healthy.

Click on image to enlarge!

There’s been a lot of empty space between US Treasury Bond prices and Fed Funds futures prices. Keeping in mind that interest rates are the inverse of the prices shown in this chart, rates on T-bonds have jumped far ahead of the Fed Funds rate which as we all know has been stuck at near zero. This same environment was present back in 2003-2004, until the Federal Reserve began hiking up the Fed Funds rate.

We’ve argued here that part of a sufficient recovery will be to create an environment that fosters growth and creativity among businesses, while preventing excess and mal-investment, which would help to turn around the deteriorating employment situation.

What’s needed to get money flowing again may very well be an incentive to save (higher interest rates) which in turn provides a growing amount of loanable funds with which to drive business.

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