In response to the e-mails of some of my readers, I again will discuss the utterances of  Treasury Secretary John Snow.  I also will repeat some methodology I presented a few weeks ago.  But I think the exercise will be worthwhile. 

The Secretary purportedly stated that he would be concerned if interest rates did not begin rising soon.  In response to his comments, long term interest rates jumped, the dollar rallied (higher yields make our currency more attractive), and stock values stumbled. 

The world was wrong in assuming that the Secretary was preparing investors for a change in policy.  Mr. Snow was merely making a forecast based upon his sense that a growing economy would push interest rates higher. 

Of course, the facts tend to support the Secretary.  A "normal" business cycle experiences falling inflation and interest rates into the beginning phase of recovery.  However, when the recovery begins to accelerate, that decline in price changes and interest rates stalls and soon reverses direction. 

However, nothing in economic theory suggests that the "normal" pattern must happen.

As mentioned in an earlier column, lenders want to get back the purchasing power they provide to borrowers.  This means that they want enough interest to compensate for the erosion in the purchasing power of the loan's principle over the time of the loan. 

Of course, no one knows what the inflation rate causing that erosion will be.  However, lenders have expectations of inflation that must be met, or they will not give up their purchasing power.  (Lenders probably also need to be compensated for the taxes paid on interest income, but those taxes do not change often enough to be included in most discussions). 

At the margin, lenders also will provide their resources to the best paying opportunities.  If a lot of borrowers are competing for resources, interest rates could rise dramatically.

When economic growth is balanced, this second factor in interest rate determination will equal the additional value provided by a new dollar invested in capital, what economists call the marginal product of capital. 

When overnight money is in equilibrium only the expected rate of inflation and the marginal product of capital are in play.  (Because the economy is not in equilibrium, the Federal Reserve currently is providing sufficient overnight money to push those rates well below equilibrium.  As economic growth becomes sustainable, such "subsidy" of rates needs to end).

However, when lenders are asked to provide funds for a longer period of time, a third factor enters.  Economic conditions change, and lenders may need to regain purchasing power before the term of the loan is over.  They can do this by selling the debt instrument to someone else.   

The price they receive for that sale will depend upon what interest rates are at the time of sale relative to the terms of the debt instrument.  If rates have increased, the debt must be sold at a discount.  The lender might also have the opportunity to take a profit if rates have fallen.  (The buyer will pay more for a debt paying higher interest on its principle than the rates currently being provided in newly issued debt instruments).  This risk of fluctuating interest rates will lead to lenders asking for a premium to hold longer term notes. 

Thus, the three main determinants of interest rates are inflationary expectations, competition for a lender's money (defaulting to the inflation adjusted marginal product of capital in equilibrium),  and a premium for lenders of longer term debt instruments (depending upon how uncertain a lender is about the direction of rates). 

Now, how does a stronger economy impact any or all of these factors?  Stronger growth might raise inflationary fears, but not if growth is caused by a higher sustainable growth path because of productivity changes.  More people will compete for funds as an economy strengthens, but this can be mitigated if the government is sharply lowering the deficit in an expanding economy.  Long term interest rates might become more volatile, but only if economic growth is missing its sustainable growth path (although it almost always does). 

Historically, Secretary Snow is on solid ground in his claim that stronger growth means higher interest rates.  However, economic theory says "it ain't necessarily so."