Real Interest Rates, Fremont, and the Land of Oz

Happy summer solstice.  I recently attended the Fremont Solstice parade and for those of you who know anything about that Seattle event, I can tell you that there is nothing I could write about in this blog that could ever be as exciting and fun as that parade.  But those visual images cannot compare to the parade going on in our financial markets!

About a year ago in June I posted an article about negative real interest rates. It turns out that it has been the most popular by far of all my postings.  http://larrydavidsonspoutsoff.blogspot.com/2012/06/negative-real-interest-rates-cannot.html

The main point of that article was to underscore how low real interest rates were last summer.  I am not sure why that post hit the mark but in any case I think it is time to update the results to summer 2013. My conclusion is that real rates are on the rise, the Fed is not soon going to change its policies, and every time the Fed tries to do the right thing the financial markets will get hysterical like they did last week.

After the Fed’s announcement that they might begin to taper the famous quantitative easing programs as early as later this year, market rates have started to rise. Expectations can be a powerful factor in credit markets, so the mere notion that rates “might” rise in the future can send them surging today. The benchmark 10 year government treasury rate increased half a point in the last month and almost 90 basis points since last summer.  So for sure – market rates are rising.

What happens to real interest rates, however, depends also on another fragile psychology factor – inflationary expectations. Most measures of expectations of future inflation rates have moved slightly downward since last year – meaning markets and surveys currently do not soon expect markedly higher inflation.  Economic problems among our main trading partners suggest continuing slack in our export sales and possibly even lower inflation in the near future.

With market interest rates rising and expected to keep rising and with inflation expected to remain stable or fall, we have to conclude that real interest rates are headed upward in the very near term. What about after that? Since market interest rates are well below their norms, it is not easy to see a reversal. But the inflation factor offers more room for story-telling and rising uncertainty. In two recent postings I made the point that just like interest rates, inflation today is well below normal values. It is only a matter of time before the effects of monetary policy, a stronger domestic economy, and a declining value of the dollar begin to push inflation back closer to 3%.

So while real interest rates are rising right now, there is still some question as to their continued future course. What happens to real interest rates will be the outcome of a race between market rates and inflationary expectations. The more inflationary expectations rise relative to market rates, the less increase there will be in real interest rates. But that outcome misses the well-known effect of changes in expected future inflation on market interest rates. The higher is expected future inflation the higher are market interest rates. In sum – this is what the medium terms holds for the real interest rate:

·        Stuff causes market rates to rise and the real interest rate to rise

·        Inflation expectations rising causes real interest  rates to fall

·        Inflation expectations rising causes market rates to rise and real interest rates to rise.

·        Result – real interest rates will begin rising with or without a rise in inflationary expectations.

And, of course, that matters because it is the real interest rates that measure the payoff to saving and investing. Significantly rising real interest rates favors savers over investors.  Rising real interest rates also cause slower economic growth so in today’s uncertain economic environment rising real interest rates are not welcome. This puts pressure on the Fed to continue its quantitative easing as markets seemed to be shouting last week.

Could the markets' lamentations be correct? What is true is that most of us do not react well to change. A change in Fed policy now is simply that – a big fat change in your face.  So the market cries out. But when the surgeon begins to wean you off the pain medicine and you cry out, at some level you understand that your future is one with zero pain  medicine. You are glad that the doctor is reducing your dose because you know it is the right thing to do.

It is the same with real interest rates. They are rising and they are going to keep rising. But Dr. Bernanke and his gang of associates are not ready to reduce the pain medicine. Investors are not convinced that the patient is healed. So the big question is when will the patient be ready. When will the Fed announce that the patient is healed and when will the patient believe it? Okay Doc I am ready to reduce the medicine because I know I don’t need it anymore.

I can’t see this happening for a while. Sure, there are numerous signs that the US economy is on the mend. But then again there are just as many worrisome signs both at home and abroad. How long will Europe’s economy struggle? Will it get worse before it gets better? China is also facing rising interest rates? Can China rein in excessive credit growth and inflation without causing an even bigger economic slowdown? Will Japan’s three-part program work after decades of stagnation? If all these places slow how will Brazil and other emerging nations manage to recover?  The world’s post-crisis economy is not back on track and this does not help confidence in the US economy.

Those are global worries – but there are plenty of domestic ones to boot. Will our dysfunctional government grow even more dysfunctional this year? Will we postpone once again legislation that address our financial and economic problems? Is the recent housing boom just a bubble? Will labor market trends swamp any reductions in the unemployment rate that might be part of moderate growth. Is higher inflation going to erode already marginal income gains?

The upshot is that the Fed is in a pickle. Everyone knows the Fed must reverse its policy. Everyone knows that rising real interest rates are coming. Yet global and domestic worries prevent the Fed from making any changes to its current policy. Every time it even imagines a change in policy the financial markets are going to be hysterical. 

We could learn some lessons from Oz. The scarecrow always had a brain and the cowardly lion was always brave.  We didn’t need three rounds of quantitative easing and we didn’t need endless stimulus from the government. From the beginning of the economic recovery we have needed good policies that aim at real problems: housing, banking, finance, immigration, healthcare costs, etc. Without apparent progress on these real problems, the Fed is stuck in a no-win position, Some people want more drugs and despite the rationality of tapering any deviation from the current stimulus will be met with chaos that will whiplash our precious portfolios.