Interest Rates

I’ve been running across a lot of commentary on the outlook for short term interest rates, where some or all of it turns on the concept of “real” interest rates.  The conclusion in any case winds up being that in order to quell inflation, the Fed has to get Fed funds higher than the rate of inflation, or at least into that neighborhood.  Extraordinarily hawkish Fed rhetoric (despite its extraordinarily dovish actual positioning) supports that view.  Various Fed officials have publicly endorsed a 50bp rate target hike at the FOMC’s next meeting, as just one of several 50bp hikes for this cycle.

It’s not going to happen.  Indeed the Fed does need to hike, if only to bring ultralow ultrashort rates into harmony with the rest of the yield curve.  But the notion that it has to get short rates in line with annual CPI growth is flawed.

For starters, subtracting an 8.5% yoy CPI increase from an interest rate to get a “real interest rate” is logically invalid.  That 8.5% is past, the interest rate is future.  It’s almost as bad as asking what you will have if you start with a glass full of milk and subtract half a glass of orange juice.  But as we’ve seen repeatedly in this forum, economists seem to be congenitally careless, bereft of logical rigor, which might help explain their abysmal forecasting and policymaking record.

Next, as I’ve also pointed out repeatedly, consumer prices are far from defining inflation.  And interest rates live in the capital markets.  Also prices of capital assets lead the rest in responding to inflation.  In the asset markets, the bogey is yields.  In short, the rates that interest rates must compete with are not rates of CPI growth, but those on assets like stocks.  There, the dividend yield is in the 2%-3% range.  That, not 8%-9%, is where rates need to be to be effective.  The strategy is to get short rates competitive with dividend yields, which then raises stock yields by cutting stock prices, and this downward pressure on asset prices then begins to work its way through the pricing network and ultimately take the pressure off of consumer prices.

Need proof?  Due to the bond market crash, we already see Treasury yields in the 2%-3% range (except for the very short extreme where the Fed is inexplicably holding them down).  And we already see heavy pressure on stock prices.  So all the Fed needs to do is get out of the way.  Short rates as low as 1.5% – consistent with the rest of the yield curve – are only about a hundred basis points or so away.

This has investment implications.  The bond market doesn’t need to fall much more to work its magic.  It may not even need to fall at all.  With so much of the market working on the premise that rates have to go much higher, bonds may even have overshot on the downside.  The upshot is that bonds are, if not compellingly attractive at these prices, no longer repulsive.

5 thoughts on “Interest Rates

  1. Peter Fife says:

    I find the above commentary very interesting… I am surprised that you claim interest rates don’t need to rise much to kill off “goods and services” inflation, assuming that is part of what your commentary implies. That may be an incorrect assumption on my part.

    However, it seems clear to me that interest rates cannot rise to 5-6+ percent as it would destroy the economy in Australia. The real estate market, Sydney especially, given the size of mortgages that people have taken out, would totally collapse the housing market, and cause so much social upheaval, I cannot see it happening. And here, all mortgages are recourse, hence the borrowers are on the hook for 100% of the loan.

    As well, a Bloomberg report claims that Sydney real estate is 39% over priced.

    It is very difficult to see how it all plays out.

    1. Bill Terrell says:

      This ties in closely with the earlier article The Fed May Actively Seek To Deflate Asset Prices. That will be the acid test for when rates have risen enough. Much as I despise the word, there will also have to be some sort of “recession” associated with it. It just not possible to go on the kind of bender the Fed has without getting a hangover.

      But the key is asset prices come down without being promptly reinflated as the Fed has been doing for years. It is theoretically possible to quash inflation without a big decline in stock prices, but that would take 10-20 years of sideways movement and another unfavorite word, “stagflation”. Moreover the process is already halfway complete – the bond market has done its part – all that’s left is for the stock market to finish the job.

      I have in mind primarily stock prices. Realty prices are little less clearly connected. But it’s safe to say that anyone overleveraged is at risk. It must be that way, since “leverage” in this context is just another word for shorting the currency. It’s just not possible for everyone to profit from borrowing up, or we could all just quit our jobs and live on it. Including the farmers that grow our food, the truckers that bring it to market, the teachers that educate our children, the doctors that treat the sick … you see where I’m going with this? Everyone could have plenty of money but nothing to buy with it. Rich but starving.

      Better for the overleveraged to get burned or for everyone to starve?

      It should take but a moment’s reflection to see that that’s much more than a remote and hypothetical risk. Unfilled jobs and empty store shelves are already a phenomenon.

  2. Bill Terrell says:

    So far I haven’t quantified how far stock prices would need to come down to arrest consumer price inflation. This is no mere oversight, because so much depends on how fast they fall – and more importantly – what happens next. As a rough guide though, getting stock prices in line with their ten year average would do it. With the crucial proviso that they aren’t sent off to the races from there. This would mean a decline of roughly 20%-30% from current levels, and a sustained period in that range. Investors would just have to get their returns in the honest old fashioned way – from dividends.

    It’s not as if stock investors won’t lose purchasing power anyway. As I discussed in The Big Takeaway, it’s not possible for the purchasing power stored in assets to exceed the body of goods and services available for purchase. The question boils down to whether this loss occurs through asset price declines or consumer price increases.

    Similar remarks apply to what level of short term interest rates would be needed. In this case however it’s more a function of how long it takes them to get there. A rate in the neighborhood of 1.50% would likely be plenty if implemented today. If it takes another year to reach, it could easily be around 3.00%.

  3. Peter Fife says:

    Hi Bill,

    All the analysis you do, how specific is it to the US situation? Does most/all apply to Australia? If not, what do you see as the significant differences?

    For example, the consensus of opinion in the financial press is that Australia is going to have a number or rate increases of 0.5%; 3-4 is probably the consensus. Do you have any reason to believe that the rate increases in Australia will differ significantly from in the US?


    1. Bill Terrell says:

      The clearest way to say it Peter is that it is what it is. Copper is copper and gold is gold, no matter where you are. Stocks is the whole world market, no matter where you are. Same with US Treasury Bills and Bonds. My analysis in general and SS in particular is not denominated in any particular currency.

      What may be different depending on where you are is that you might have substantial investments in your local markets that we don’t cover. But what we do cover is the same everywhere.

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