For a period of one year, between July 2003 and July 2004, the Federal Reserve Board kept its key policy-setting interest rate at only 1.00%. This was a historically low level for the federal funds rate and was actually negative when the rate of general price inflation in the United States was taken into account. A strong case can be made that most of the problems that we have faced in the economy over the past several years can be traced back to that super-low interest rate policy.

The ultra-low interest rates led to a massive expansion of credit. There were three primary consequences, two centered in housing markets and one in consumer spending. On the housing side, speculators bid up house prices in many areas to an alarming degree. At the same time, teaser mortgages stimulated demand for housing from low-income earners. On the consumer side, existing home owners renegotiated mortgages and went on a spending spree, with many of those purchases coming from China.

Rates inevitably had to rise again as inflation heated up. In early 2006, they peaked at 5.25% for the federal funds rate. The eventual result was to stop speculative home-buying in its tracks and to set in motion the sub-prime mortgage collapse. Subsequent re-adjustments in mortgage payments came to a head in August 2007, with the prospect of massive mortgage foreclosures and a tangled web of debt liability. Housing starts still have not recovered and have dropped by nearly 60% over the past two-and-a-half years.

The next step in the unravelling was the financial crisis that saw the need for major bank and brokerage firm bail-outs. At the tail end of last year, the stock market lost appeal as a repository for funds. With both real estate and stocks in at least temporary disrepute, cash investments turned to commodities. Commodity prices were already on the march upward due to earlier consumer-goods demand that was being met by emerging nations. In turn, this required massive infusions of raw materials.

The economies of emerging nations were already being raised by consumer demand from the west. This was putting pressure on agricultural prices as a growing middle class wanted a more varied diet on top of the usual staples. However, the most significant commodity price advance has been in the area of energy. This has been the latest development to sideswipe the economies of North America. The international price of oil has doubled over the past year and increased by a factor of seven since early 2002.

The increase in the price of oil is now seriously delaying economic recovery. The positive effects of the Fed’s large cuts in interest rates − from 5.25% back down to 2.00% over the course of the past year − are being undone by the increase in the price of gasoline. Consumers have turned extra cautious. Who wants to make a major purchase when it has become so hard to budget for family expenditures? The next round of major economic trouble appears to be brewing in the auto sector.

Vehicle demand is being altered significantly by the high gasoline prices. The U.S. is finally starting the process of switching to smaller, more fuel-efficient automobiles. Compared with SUVs and trucks, these are lower-priced and carry a lower profit margin. The Detroit Three automakers are again faced with making wrenching adjustments in areas such as switching product lines, closing plants and cutting back employment.

A Contrarian View on Interest Rates

That brings us up to the present. How do we get out of this mess? Let me make a case for a contrarian view on interest rates. This may seem like a harsh thing to say (particularly to those in construction), but the current level of interest rates is probably too low.

The federal funds rate is back down to only 2.00%, which in “real” terms (i.e., inflation-adjusted) is -2.00%. On the surface, this is excessively stimulative. Admittedly, however, there is a problem in assessing how stimulative current interest rate levels are due to the fallout from the financial crisis and resulting liquidity crunch. Loan approvals are harder to get than in the past and many of the riskier lenders have been squeezed out of business.

In terms of the problems that we are facing − consecutive waves of speculation that have swung between the stock market, real estate and commodities (oil, gold, etc.) − there may really be only one answer. That answer is to restore the value of money by raising interest rates.

Longer-term, this will have three positive impacts. First, it will send a signal that more moderation is expected from the economy. This will ease speculative fervour and the result will be lower commodity prices.

Second, money is an asset class on its own. Higher interest rates will provide an incentive to put money into savings accounts and investment certificates. Again, this will help to dampen speculative swings by providing more investment options.

Third, the world price of oil (as well as several other commodities) has been moving in inverse-relationship to the value of the U.S. dollar. In this way, commodity prices have been a hedge against U.S. dollar declines and producers have managed to maintain their “currency-adjusted” returns. A higher interest rate policy will lend support to the U.S. dollar and take some of the pressure off commodity prices.

Alex Carrick

Find Canadian construction-related economic articles in Canadian Construction Market News and in the Economic Outlook section of Daily Commercial News.

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