Although it is important, inflation is only one of three factors that determine interest rates. Actual rates usually include a base value, similar to rent paid on money, and a default risk in addition to an inflation factor. Right now rates are low because inflation is low, and many investors expect it to stay low while the risk of default is considered minimal.
If investor perception of default risk rises, so will rates. This happened in the Great Depression, where deflation was accompanied by rising rates as the risk of default climbed.
In the current environment, budget squabbles in Washington could lower investor confidence and raise concerns about repayment. This is unlikely, especially with the Federal Reserve buying more than $1 trillion worth of government-backed bonds a year.
More likely, we could see a shift of confidence in the municipal bond market. With several California cities in bankruptcy and other cities struggling to avoid that fate, this could be the first market to see higher rates. Current yields on investment-grade munis are only slightly higher than rates on U.S. Treasurys. Higher rates would lead to higher financing costs for cities and states and that could make it even more difficult to meet future pension obligations, which could develop into a future crisis.
Corporate bond rates could also rise, even if Treasury rates remain at historic lows. This could happen if the risk of corporate defaults rise, which could happen if consumer spending slows.
Consumer credit might be the market most dependent on lender confidence. Increased risk of consumer defaults could push rates up and trigger a recession.
Inflation is a concern, but should not be the only concern of rate watchers. A small change in the risk premium in municipal bonds, corporate bonds or consumer loans could be the real driver of higher interest rates in the future.
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