amused worried by the persistence of the “Central Banks are manipulating rates!” myth. Particularly among so many self-identified free market types. It is a comforting myth. And yes, the facts point in a deeply discomforting direction. But FRED* doesn’t lie. Conclusion first. Facts follow.
- The market is driving rates. The Fed is dancing to the market’s tune. Its a Wizard of Oz act.
- The market has told us two things.
- Short-term rates above 2% are too high.
- Short term rates around 1.5% might be OK.
- Rough but accurate math: Long-Term Rate = Economic Growth Rate + Inflation Rate. Re-arrange that and you get Inflation = Long-Term Rate minus Economic Growth.
- The market gives us 30 year (2.23%) and ten year (1.76%) rates.
- The San Francisco Fed estimates long-term economic growth of 1.5%-1.75%, based on immutable (and low) population growth and a reasonable guess on productivity growth.
- That solves for inflation between zero and o.5% (1.76% – 1.75% = 0.01%, 2.23% – 1.75% = 0.48%)
Inflation between 0% and 0.5% is scary as hell.
If you don’t believe me, google “deflation” and its consequences (or wait for a future blog post). No wonder so many people are sticking to the more comforting narrative that “the Fed is manipulating rates.” Because deflation is super terrifying. Even a permanent low rate scenario is pretty terrifying too.
A lot of people are ignoring the above, But the facts are pretty clear. The above seemed highly plausible a few months ago. The recent upward turn in long-term rates makes it even more clear. The market is marking up future prospects as the the Fed cuts short-term rates, the market started raising its long-term rates.
So we might be OK with short-term rates around 1.5%. Which is a heck of a lot better than a macho Fed-caused recession from over-high rates. But it leaves no room for inflation in that long-term growth + inflation equation. And that is the ugly truth.
The graph below shows
- The Fed’s short-term target interest rate (red line)
- The market’s 10 and 30 year bond interest rates starting Jan 1 2018.
[iframe src=”https://fred.stlouisfed.org/graph/graph-landing.php?g=piQt&width=670&height=475″ scrolling=”no” frameborder=”0″style=”overflow:hidden; width:670px; height:525px;” allowTransparency=”true”>
The Fed nearly doubled its target rate over 2018 – from 1.25% to 2.25%. The (free) market played along until early November. Note that market rates started tanking before the Fed’s last rate increase around December 21. The S&P500 was tanking too.
The Fed, chasing the market’s lead, started cutting its target rate down to 1.75 today. Markets kept leading the Fed all the way. Today, with the Fed’s rate at 1.75 and pretty clear signals of another cut to 1.5%, the market did something different.
Market rates have started going up. The 10 year and the 30 year are ticking up. The yield curve has un-inverted itself.
Yield Curve – 10 Year Treasury Minus the 2 Year Treasury
[iframe src=”https://fred.stlouisfed.org/graph/graph-landing.php?g=piS3&width=670&height=475″ scrolling=”no” frameborder=”0″style=”overflow:hidden; width:670px; height:525px;” allowTransparency=”true”>
* FRED is the St Louis Fed’s excellent and free data charting system. “Download, graph, and track 590,000 US and international time series from 87 sources.”