Despite recent tightening by the Federal Reserve Board, interest rates remain relatively low both compared to past decades and the current inflation rate. Persistent Inflation will lead to a long period of higher interest rates.
Introduction:
Some pundits believe inflation has peaked, and it is now time to buy bonds. These pundits offer an inaccurate macroeconomic assessment and bad financial advice.
Comment One: The nominal 10-year Treasury interest rate is roughly where it was in February 2014, but inflation is substantially higher.
Both in February 2014 and September 2022, the 10-year constant maturity interest rate was 3.4 percent.
- In February of 2014, the one-year inflation rate was 1.6 percent. It had hovered close to that level for the entire year.
- The reported inflation rate in August of 2022 was 8.2 percent up from 5.2 percent, 12 months early.
People purchasing 10-year bonds are now earning far less than inflation. We should expect this gap to narrow and bond yields to rise unless inflation suddenly plummets.
Comment Two: Interest rate comparisons based over data from the last 10 or 15 years are deceptive because rates have been abnormally low.
Comparisons to average and high interest rates over a longer period are more relevant.
- This graph shows the 10-year rate reached 5.0 percent in June 1967 and stayed above 5.0 percent until July 1998, literally 31 years. The current 10-year rate is 3.5 percent.
- This graph reveals that while the current two-year constant maturity rate is at its highest level since 2007, it is also lower than any rate that existed between 1976 and August of 2001.
Comment Three: The reduction in interest rates requires a decrease in inflation, an unlikely outcome in the near term.
In a previous era, the Federal Reserve used two tools, higher interest rates and lower money supply, to reduce inflation. Today the main tool is higher interest rates, which remain below historic levels.
The money supply has grown robustly during the pandemic and is at a high level compared to the size of the economy. The impact of past increases in the money supply on the price level has not been fully realized. Whether the Federal Reserve Board can reduce the inflation rate without reducing the money supply is questionable.
Comment Four: Wages are likely to continue to increase, even if there is a recession, leading to
significant wage-push inflation over the next few years.
There are many reasons why worker compensation is likely to continue to increase over the next few years.
- One way to reduce the gap between job openings and people, noted here, is to increase immigration, an outcome that appears unlikely in the current political environment.
- Many workers are burnt out from COVID and resistance to returning to the office can increase wages in some areas, especially for firms and industries dependent on in-person work.
- There is a shortage of teachers, nurses, airline pilots, long-haul drivers, and highly skilled computer analysts. These shortages won’t be instantly reversed with the advent of a recession. The shortage of nurses guarantees that health care costs, a key component of both the CPI and workers compensation will not fall in the near or intermediate term.
- Some unions have recent won large increases in compensation, with a recent example being the rail unions. Increases in rail transport prices will increase the price of transported goods.
The wage-push inflation will make it very difficult to reduce inflation and return to the abnormally low interest-rate environment.
Comment Five: The housing component of the CPI will not fall with an increase in interest rates.
The housing price component of the CPI described here is based on imputed rents. An increase in mortgage interest rates generally leads to higher observed and imputed rents.
The increase in interest rates will reduce the affordability of new mortgages and decrease house prices. However, relatively few households buy or sell a house in a particular year. Increases in interest rates, which delay home purchases, can increase both actual rents and imputed rents used for the CPI housing cost calculation.
Increases in the housing cost component of the CPI, stemming from higher interest rates, will contribute to inflation despite a decrease in aggregate demand from higher interest rates.
Comment Six: More supply shocks leading to more inflation are likely.
The most likely supply shock from the Ukraine war involves higher food prices from disruptions in grain and fertilizer exports.
Concluding Remarks: How should investors respond to this economic outlook?
Avoid long-term bonds, anything with a maturity more than two years.
Avoid bond ETFs. Even shorter maturity ETFs and ETFS that own TIPS bonds have been problematic over the last year.
Purchase at least $10,000 in Series I Bonds every year from Treasury Direct. Additional purchases beyond the $10,000 limit are possible through tax refunds, trusts and S-corporations. For details go to essay five here.
Allocate a small share of your wealth to two-year Treasury bonds. The purchase and maturity dates of the bonds should be staggered to create constant liquidity when the bonds mature. Ownership of bonds is preferrable to investments in bond ETFs because bonds return the initial investment at par value on the maturity date.
Authors Note: David Bernstein is the author of eight essays published in Financial Decisions for a Secure and Happy Life.