Bob Carlson

I always warn people against using rules of thumb and other easy tools to make decisions. A good example is interest rates, bonds, and deficits. At the beginning of 2011, most analysts were convinced interest rates in the U.S. would rise. They had to rise, people reasoned, because the U.S. deficit was so high that it would push interest rates and inflation higher. But the opposite happened. That’s because the economy and markets are complex. There are many factors at work, so you can’t rely on a simple A+B=C formula.

John Makin of the American Enterprise Institute explains why interest rates remained low in 2011. He identifies three factors: inflation remained under control; economic growth was less than expected; and investors put a premium on safety. In fact, while the theory that high budget deficits cause higher inflation and interest rates seems sound, there hasn’t been a strong correlation between those factors in the U.S. What’s likely to happen to interest rates in 2012? Here’s a tease:

Looking ahead, 2012 may see fewer risk events shocking investors than occurred in 2011. The recent rise in stock prices suggests that some investors are hoping for such an outcome. But the persistence of low interest rates on high-grade government bonds suggests residual caution among many investors who apparently are more worried about weaker growth and volatile credit risks among low-rated government bonds than they are about higher inflation.