Secret of Higher Interest Rates Revealed

The rise in long-term interest rates isn't a drag on growth; it is a sign that the economy is picking up speed.

I can only imagine what the average person must think when he reads what passes for economic analysis in the daily press. Let me give you an example.

Last week, on the heels of strong economic data, the 10-year Treasury yield closed above 3 percent for the first time since July 2011. That was enough to send up flares and elicit warnings about the effect on economic growth.

"Some economists are worried that higher interest rates might start weighing on economic growth," according to the Dec. 28 Wall Street Journal. "But many investors and analysts expect little or no impact as long as future rate rises are gradual."

OK. Got it. Or consider this: "Rising bond yields present fresh Fed challenge." Actually, that quote was from the April 29, 2009, edition of the Financial Times, but it helps prove my point that this misplaced obsession never changes. (What also doesn't change is my attempt to straighten people out.)

Long-term interest rates move pro-cyclically. In fact, the rise in rates generally precedes confirmation of stronger economic growth because the invisible hand (aka Mr. Market) senses an increased economy-wide demand for credit, which pushes up the price. That's why the slope of the yield curve -- the spread between the pegged overnight rate and a long-term market rate -- is the leadingest of the leading indicators. A steeper yield curve is expansionary. It's an inducement for banks to increase the supply of credit.

If the increase in long-term rates threatened the economy, you have to ask yourself: How do we ever get an acceleration in growth? In this model, higher interest rates slow growth; slow growth lowers interest rates. The Federal Reserve? Who needs it? No wonder bond traders were once considered Masters of the Universe.

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