The first half of the interest rate forecast is very simple: short-term interest rates will remain in microscopic territory through 2013. Less certain is the outlook for long-term interest rates, most likely a story of rising yields.

The forecast of low short-term rates is both the Federal Reserve’s announced intention and logical as well. (The two are not always the same.) The basis for the Fed’s plan is that the economy has a great deal of slack in it, and some of that slack will remain two years from now.

Critics of this view are worried about inflation. Jeffrey Lacker of the Federal Reserve Bank ofRichmond voted against the latest Fed decision on the grounds that inflation would rise and require an interest rate hike. That’s possible but, I think, highly unlikely. Historically, inflation has risen when money supply growth is excessive. One can point to the antecedents of money supply growth—increases in the monetary base—as evidence that inflation will accelerate. Currently, however, the connection between the monetary base and the money supply is not as tight as it used to be. Huge increases in the base have not led to large increases in money, because banks are holding on to excess reserves.  For inflation to accelerate, the money creation process must actually lead to increased spending. That hasn’t happened, and the forecasts of moderate economic growth indicate weak spending growth.

Skeptics may believe that the huge stimulus to the monetary base will eventually work its way into the money supply, and then to spending. That will eventually happen, but the current and near-future weakness of loan demand will delay that rebound. When the surge in money supply actually hits, then the Fed will have to raise interest rates. I believe they will but not in 2012 or 2013.  Maybe 2014 is the year.

Long-term interest rates are a different story, driven mostly by global credit demand, which in turn varies with the global economy. For dollar-denominated debt (such as United States Treasury bonds and mortgages), adjust world interest rates for changes in U.S. inflation.

The global economy is growing and should continue to do so, barring a European financial meltdown. Our inflation is unlikely to accelerate or decelerate, so changes in long-term interest rates will pretty much reflect world credit demand. I expect long rates to rise by about a percentage point a year for 2012 and 2013, which would leave the ten-year Treasury bond around four percent and the 30-year mortgage about 5.6 percent at the end of 2013.

Interest rate forecasts are not high precision numbers, and nobody should bet the farm on any forecast. The biggest fly circling the ointment is Europe and the potential for a financial meltdown. If that happens, look for the yields on high grade securities to fall as investors seek safe havens. At the same time that safe assets fall in yield, the interest rates on riskier bonds will rise sharply. Again, this pattern occurs only if Europe fails to muddle through its current crisis.

Business Issues:

From a business perspective, this is a good time to float long-term debt, probably the best time you’ll see for years and years to come. Short-term credit lines don’t need to be locked in, given the flat outlook for short-term rates.

Investor Issues:

This is an ugly time for fixed-income investors. My family recently reviewed our asset allocation. We’re light on bonds compared to the investable universe allocations. I really like be diversified, but I couldn’t bring myself to add more bonds in this low-yield environment. Maybe in a couple of years.

For those of you interested in what public policy should be given this economic outlook, check out my Businomics blog post, What Should the Government Do About the Economy.

Historical Perspective on Interest Rates

If you like history, check A History of Interest Rates.