Interest Rates: Chaos Theory Seizes Economic Policy

May 29, 2008 by Douglas A. McIntyre

According to chaos theory systems that exhibit mathematical chaos are deterministic and are therefore orderly in some sense. Interest rates share something in common with that definition.

Lowering interest rates is supposed to put more liquidity into the market. That does not really work if the banks taking the money do not spread it to their customers. The customers remain part of a much higher interest rate environment and the benefits are lost down the food chain.

The Fed has succeeded, at least for the time being, in quieting the banking crisis. But, it was Three Card Monte. Opening a special discount window to money center banks and then investment houses allowed these institution to trade toilet paper for cash. Overall lower rates had less to do with the institutional healing process.

Now, by many accounts, the Fed needs to raise rates to keep inflation, driven mostly by oil and commodities, down. Two members of the agency have said rates may have to move up. The FT reports that "A sell-off in the US bond market pushed the yield on 10-year Treasuries above 4 per cent on Wednesday for the first time since January, as investors bet that pressure from record oil prices would force the Federal Reserve to raise interest rates this year."

It sounds like a done deal.

But, because the man on the street did not benefit from interest rate cuts and interest rate increases are not likely to cut gas and food prices soon, where is he left? Mortgage rates did not come down. If anything, banks became more parsimonious for fear of taking on bad debt. Those out of work due to the slowdown cannot pay mortgages. Those who can may have to decide whether to keep their homes on the one hand or drive their cars and buy food on the other.

When Dow Chemical (DOW) raised prices on most of its products yesterday, it blamed the government for having a poor energy policy. There is a great deal of evidence that, short of building 50 nuclear power plants in the next two years, the Administration and Congress cannot do much. OPEC & Co. are not shipping enough oil.

Cutting interest rates was supposed to help the consumer. It does not appear that it happened. Raising interest rates will save the consumer from inflation. If the global supply and demand for food and fuel were in balance, that might be true. But, they aren’t.

Douglas A. McIntyre