Tuesday, June 19, 2018

The Fed and the Next Recession

I had so much fun last week graphing wage changes that it spilled over to another graph this week. This time, the graph plots interest rates.

Why interest rates? Because interest rates are interest-ing? Ha ha. Of course they are interesting. But a better reason to focus on interest rates today is because the worry-warts are screaming that the Fed is going to send us straight to recession hell. While many of you hate the Fed and wish we were back in the good old days of the gold standard when there was no Fed or when the Fed was reduced to less importance than a milk delivery driver, the rest of us are less extreme. But we do worry that the Fed is prone to over-reacting, thereby becoming the winner of the contest for the most severe unintended consequences. We worry in 2018 that inflation will begin rising, the Fed will raise interest rates, and the economy will come crashing down around our ears.

So, we are all riveted on interest rates. And if we looked at interest rates in the summer of 2018 and compared those rates to those in mid-2016 or even mid-2017, we might get a wee bit scared. But the point of today is to create a longer historical perspective.

First, let’s define the interest rates plotted below. Both are market rates* on government securities. The top line is the rate on 30-year Treasury Constant Maturity Bonds. The bottom line is the rate on the 10-year Treasury Constant Maturity Bond. Neither of these is a policy variable directly controlled by the Fed. But both are very popular and are generally taken to be barometers of market interest rates. Many market rates are influenced or tied to the 10-year rate. The 30-year rate is a good proxy for longer-term bonds in general.

If the Fed implements a policy to raise interest rates, it usually conducts an open market operation whose intent is to change something called the Federal Funds Rate (FFR). A change in the FFR then raises the cost of funds and ought to impact many market interest rates. A successful Fed policy, therefore, will result in a wide swath of interest rates changing even though the Fed only directly controls the FFR. It is possible, however, that many of these market rates do not behave as the Fed desires.

The graph shows that market rates have risen in predictable fashion in 2017 and 2018 as the Fed raised the FFR. The FFR was set at virtually zero from around 2009 through most of 2015. Notice, however, the roller-coaster rides of both rates in the chart. The trend of both rates was clearly downward but there were very clear episodes of rising/falling cycles within that downward trend. With the FFR constant, there must be other things that affected interest rates. Notice the increases in rates around 2011 and then again in 2012 to 2014. Both of those periods saw rates rise and then fall by about as much as they rose. All this happened with a near zero FFR. 

If these other things could be important from 2009 to 2015, then presumably they might be important in 2018 and beyond. That is, if the Fed decides to raise the FFR rate in 2018, perhaps market rates will not follow. Perhaps other factors will keep rates from rising or even contribute to a fall. And this means knee-jerk forecasts that a Fed tightening cycle will lead to a recession could also be wrong.

What are these other factors that might prevent market interest rates from rising as the FED increases the FFR? First, consider real GDP growth in the US. Rapid growth often puts pressure on financial markets as the demand for loans exceeds the supply. But who is seriously forecasting strong economic growth in the US? While some forecasters imagine faster growth emanating from the recent tax cuts, few of them think growth will remain strong for very long. A barrage of studies worry that low productivity and labor supply growth imply weak US growth for the foreseeable future. Look at the diagram. The 30-year rate is barely rising compared to the 10-year bond.

Second, interest rates often reflect expectations of future inflation. Higher expected inflation means a lender gets paid back in dollars that are worth less. So they demand a higher interest rate today to compensate for the loss of buying power tomorrow. It is true that some forecasters believe that inflation is going to increase in the USA, but few see reasons for sustained higher inflation in the future.

Third, the value of the dollar is important for interest rates. If the dollar declines in value relative to other key currencies, this leads to more inflation in the USA. If one believes the dollar will fall in the future, this means investors will want to move out of US assets. The selling of these US assets raises interest rates. The dollar has not been depreciating lately. It has been rising in value. This reduces inflation and interest rates. Believing the dollar will continue to rise also lowers interest rates*.

Fourth is the risk scenario in other countries. As investors worry about economic problems in Europe (Italy, Britain ) and Asia (Korea, Japan), they increasingly want to invest in the USA. Even with warts in the USA, what matters is who has the bigger warts. The more negative news you read about Europe and Asia, the more the global appetite for US assets increases. This drives the price of US bonds upward and reduces interest rates. 

In summary: Modest US economic growth, stable inflationary expectations, a higher value of the dollar, and economic riskiness in Europe and Asia should all combine to put downward pressure on interest rates.

I cannot predict the future any better than you can. Some folks want you to believe that Fed policy will raise market interest rates and take the air out of the US economy. While Fed policy sometimes works that way, 2018 and 2019 are not typical years. It is altogether possible that the Fed will continue raising the FFR, and the result will be a continued slow growth economy with relatively stable inflation and interest rates. 

*Students often have trouble with idea that higher bond prices mean lower market interest rates. This is because we forget the these bonds have a fixed coupon yield or return. One bond might promise 5% to the holder. Thus a $100 bond gives whoever buys the bond $5 each year. If you buy such a bond in the open market on a bad day when the price is only $50 then you get $5 interest on your $50 investment. That's a 10% return! The lower market price for the bond means a higher market interest rate. If you buy the bond on a big day for the bond market, you might pay $200. You still get interest of $5 and therefore your market return is only 2.5%. So we get the general rule -- the higher the market price of the bond the lower the market return. The lower the market price of the bond the higher the market return. 

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