Discussions of the transitory nature of inflation have been common these days. The more important question that financial institutions may be forced to address in 2022 deals with the transitory nature of negative real interest rates.
We are at a highly unusual position between interest rates and inflation. The inflation rate is higher than the 30-year fixed mortgage rate, creating negative real interest rates. In the past 50 years, core inflation has exceeded mortgage rates only twice before now – for 12 months in 1974-75 and for two months in mid-1980. This unnatural pricing relationship can encourage destabilization through excessive speculation and contribute to income and wealth disparities.
A relatively small group of people wield dominating influence in the market for interest rates in the U.S. We need these leaders to accurately forecast and wisely select the outcomes of alternative current rate setting choices and prioritize the costs and benefits to all the stakeholders in a way that accommodates maximization of the collective good.
When we keep throwing gasoline on a fire, in the form of ongoing fiscal and monetary stimulus, it is increasingly hard to accept the forecasts coming from those in control of the gas when they consistently predict the fire (inflation) will die off soon. Supply-chain issues are real, but pinning all of the blame there seems overstated.
Inflation is a self-fulfilling event that convinces people that prompt buying action is better than inaction; that waiting is a bad choice because goods and services will only get more expensive. Current government policies are a grand experiment that we have never tried before under these circumstances. While prolonged high inflation is not inevitable, don’t expect it to fade anytime soon based on the situation and the policies being pursued.
Zero overnight interest rates started out as life support for the economy more than a decade ago and have since become a performance enhancer. When we had a problem with excessive unemployment and falling prices during the Great Recession, zero overnight rates had a valid purpose. Now, in the later stages of the pandemic, when we have excessive inflation and low and declining unemployment, we are told again that we need zero rates. We are applying the same medicine for diametrically opposite conditions.
The U.S. bond market has become the largest market not generally subject to free market forces on the globe. History shows that mispriced markets eventually lead to some kind of unintended consequences. What could that look like? Could we now be destined to experience the consequences of overplaying the benefits of zero overnight rates?
Let’s consider what this environment has done to the fixed income securities market. SIFMA reports that the aggregate U.S. fixed income market grew to over $50 trillion at the end of 2020. This growth last year was greater than it was for 2010 to 2015 combined.
Banks have trillions of dollars in new money on deposit that is broadly owned by the population. People feel that they have been held back by the pandemic – do we expect the population to restrain their consumption in the face of persistent inflation?
A case can be made that we are overestimating the economy’s fragility because we have consistently been told for more than a decade that monetary authorities are taking aggressive policy actions to deal with economic stress. Do we really believe that incremental increases in overnight rates by the Federal Reserve would crash all markets even though we had overnight rates above zero for decades?
Wages, equities and real estate all benefit from artificially low interest rates and unending government stimulus. This situation also contributes significantly to the cryptocurrency attraction. The Fed’s respect for crypto may be one key to prompting rate action, even though there are so many other valid reasons to do so.
Does it not seem obvious that movement toward interest rates determined in a competitive market environment would be a healthy thing? Why not promptly and systematically ratchet overnight interest rates up to 100 to 250 basis points? Under current circumstances, this is highly unlikely to create a traditional recession, though it would clearly slow the residential real estate boom.
If the Fed methodically raised interest rates modestly, how could that not be the right move at this time from a long-term economic perspective? And if not now, when?
Neil Stanley is founder and CEO at The CorePoint. The views and opinions expressed in this article are those of the author and do not reflect the views of BAI.
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