Do We Become Japan? Is Someone Trying to Say “Fire” Very Quietly in a Crowded Theater?

Trying to pull some recent threads together.  Still puzzling things out myself.  The charts below are the crux of the question.  Look at the bottom (purple) line – the Fed Funds rate –  vs the market-driven rates above it.

  1. The Fed has been raising its (short-term lending) rate since 2016 (purple line).
  2. The market-driven 10 year Treasury rate (green line) barely budged.  The Fed raised its rate zero to 2.4%.  The ten-year nudged up from 2.3% to 3.2% until it tanked back down to 2.6% when the market balked at the Fed’s last rate raise (Fall 2019).
  3. Corporate bonds followed the 10 year.  Which is what they are supposed to do.
  4. The Fed raised the rate it controls.  The market lowered the rates it controls.  All this noise and shouting about the yield curve inverting (when long-term rates are lower than short-term rates) ignored that humans were the ones doing the inverting.  The Fed led and the market didn’t follow.  Just like Greenspan’s “conundrum” years in the mid-2000’s.
  5. Clear as day, the charts below show an impotent Fed.   We have no Wonderful Wizard of OZ who can grant all our wishes.  Just old men making noise and smoke…

It seems pretty clear (to me at least) the bond market’s negative reaction is the mechanical reason the Fed got all dovish and signaled no more rate rises.  If you are trying to lead a charge and the troops start retreating instead…

That explains the Fed’s action.  But it doesn’t explain the market’s reaction.   What the heck is going on out there?  Why are long-term rates (the sum of real economic growth % + inflation % + risk %) only summing up to 2.6%?

  • Is that 2% growth and 0.6% inflation?
  • Or 2% inflation and 0.6% growth?
  • Or 1%-2% deflation and 3%-4% growth?

In some ways the answer doesn’t matter because all of the above are pretty terrifying.  And we HAVE seen this movie before.  In Japan.  That is about as far as I’ve managed to get.  Right now my brain is trying to wrap itself around the weird physics of the current scenario.  What the heck does that section in bold (from the 2019 American Economic Association (AEA) Presidential Address) actually mean?  Is this someone trying to say “fire” very quietly in a crowded theater?

[What is] the role of deficits and debt if we have indeed entered a long-lasting period of secular stagnation, in which large negative safe interest rates would be needed for demand to equal potential output but monetary policy is constrained by the effective lower bound. In that case, budget deficits may be needed on a sustained basis to achieve sufficient demand and output growth. Some argue that this is already the case for Japan, and may become the case for other advanced economies. Here, the results of this paper directly reinforce this argument. In this case, not only budget deficits will be needed to eliminate output gaps, but, because safe rates are likely to be far below potential growth rates, the welfare costs of debt may be small or even altogether absent.

Olivier Blanchard – 2019 American Economic Association (AEA) Presidential Address at the AEA annual meeting on the topic of “Public Debt and Low Interest Rates.” He sets out new theoretical foundations for how to think about fiscal policy and debt. Ben Bernanke provided the introduction.

A bonus graph going back to 1970.  The market once did respond quite nicely to the Fed’s rate moves.  That broke down in the 2000’s.

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