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.