Should the Fed Pivot?

Short Answer is no. Interest rates have been artificially low for 15 years and remain below historical averages. The long era of artificially low interest rates created a bubble that was unsustainable. It is this bubble leading to a financial collapse, not Fed tightening, that will lead to an economic downturn.

Some perspective:

The Federal Reserve Board is supposed to be above political pressure.  That tradition along with several others died in the Trump era.  Remember when Trump was actively considering firing Powell.  More recently, it was Senator Warren that argues that Powell wants to throw Americans out of work even though the unemployment rate remains at 3.5 percent.

The other source of political pressure is from market participants, both participants in bond and equity markets who are used to low interest rates.   The taper tantrum of 2013 occurred when the fed announced it was going to gradually reduce asset purchases. Today the pressure is on the Fed to pivot and halt increasing rates.  Famous Fund manager Cathie Woods now writes that Fed tightening can lead to a deflationary post.  

Recession is possible but deflation is not a credible concern.  Substantial inflation now exists and will not go away soon. The economy would be much better off now if Powell had ignored Trump’s threats in 2018 and had recognized that inflation in 2022 was not transitory. 

The primary cause of the coming recession is not Fed tightening.  It is instead the collapse of a stock bubble that was the result of excessive monetary growth.    This bubble and collapse could have been prevented if the Fed had previously ignored Wall Street whims.

Analysis:  Interest rates are not high compared to past figures, especially given the level of inflation.  

The first set of figures for the 1-year and 10-year constant maturity bond rate and inflation cover the 1953 to 2022 period.

  • The current October 2022 one-year constant maturity rate is 8 basis points below the 1953 to 2022 median.
  • The current October 10-year constant maturity rate is 106 basis points below the 1953 to 2022 median.
  • The current inflation rate is 583 basis points above the 1953 to 2022 median.

The fact that the interest rates are low compared to historical figures when inflation is high is remarkable because borrowers generally require an interest rate that compensates them for inflation.

The second set of figures involves comparisons of current rates to the 1971 to 2023 median.  The shorter more inflationary period allows for inclusion of the 30-year mortgage rate.

  • The current rate is 356 basis points lower than the median for the 1-year bond, 469 basis points lower for the 10-year bond, and 315 basis points lower for the 30-year fixed rate mortgage, even though the current inflation rate is 287 basis points above the median.

Interest rates did rise quickly in 2022 primarily because rates were at such an artificially low level.  I compared actual September 2022 interest rates to predicted interest rates generated by a simple distributed lag model.   

  • The one-year interest rate rose a bit more than expected by the model.  The actual one-year rate was 3.9.  The predicted rate was 2.9.
  • The actual 10-year bond rate of 3.52 percent was very close to the predicted rate of 3.45 percent.

Concluding Remarks:  Interest rates are still below their historical medians.  When I look at likely interest rate outcome based on inflation and future inflation expectations, I see greater likelihood of higher inflation leading to higher interest rates and capital losses on bonds than interest rate declines and gains in bond prices.  

A Federal Reserve Policy pivot would increase my concern about higher inflation and interest rates.

I am not optimistic that the Fed Policy will lead to a soft landing, because inflation over the next few years may be driven by wages and low labor force participation, which could best be addressed by a more lenient immigration policy and tax incentives encouraging work.  

Authors Note

David Bernstein is the author of two recent policy memos.  One memo examines alternatives to the Biden Student Debt Plan. The memo argues that Biden’s student debt forgiveness plan and expansion of Income Based Replacement Loans will prove ineffective.  Several alternative policies including elimination of debt for first-year students, policies that promote on-time graduation, and interest rate concessions coupled with more stringent collection efforts on older loans near maturity are proposed and analyzed.

Another memo, A 2024 Health Care Reform Proposal , considers substantive health insurance reform.  The policies proposed here include ideas to provide continuous health insurance coverage during job transitions, improvements to health savings accounts, the elimination of short-term health plans, and a proposal to address problems caused by narrow-network health plans.

David Bernstein is also the author of eight personal finance memos contained in Financial Decisions for a Secure and Happy Life.  The book provides guidance on a number of topics including the choice between saving for retirement and reducing student debt, the choice between traditional and Roth retirement accounts, ways to minimize loss of retirement income from high-fee 401(k) plans and the advantages of the use of Series I Savings Bonds.  This $7.00 40-page memo could save you tens, even hundreds of thousands of dollars over a lifetime.

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