Tuesday, 22 of January of 2019

Economics. Explained.  

Category » Interest Rates

Mortgage Rate

December 5, 2018

Right after the election in November 2016 mortgage rates  jumped quickly from 3.5% to 4.2% as market participants believed that President Trump’s proposed individual and corporate income tax cuts.  repatriation of corporate earnings currently locked overseas, and significant relief from the currently onerous regulatory burden, would boost GDP growth significantly, boost inflation, and push long-term interest rates higher.  Additional Fed tightening this year coupled with a gradual increase in inflation has boosted the 30-year mortgage rate to 5.0%

We expect the Fed to leave the funds rate at 2.2% at its meeting next week, but then increase rates three times in 2019 which would boost the funds rate to 3.0%.  If that is the case and inflation remains fairly steady, we expect the 30-year mortgage rate to climb to 5.3% by the end of 2019/.

 

 

Stephen Slifer

NumberNomics

Charleston, SC


Fed Funds Rate

December 3, 2018

The federal funds rate is the overnight rate that banks charge each other to borrow/lend  reserves.  Some banks have more reserves than they need.  Others (principally large banks) are short of reserves and must borrow from other banks in the system, typically on an overnight basis.  The rate at which this borrowing takes place is known as the fed funds rate.  It is the only rate that the Fed can directly control.  Most other short-term interest rates like Treasury bills, CD’s, commercial paper, etc. are very closely linked to this rate, so when the Fed tightens or eases all other short-term rates move in the same direction by essentially the same amount.

Once the recession began in December 2007 the Fed tried to stimulate the economy and ultimately pushed the funds rate almost to 0%.  It remained at that record low level until December 2015.

In December 2015 the Fed decided it was time to alter its policy and push the funds rate towards a more “neutral” policy stance.  So what might be regarded as a  “neutral” level for the funds rate?  The answer lies in the relationship between the funds rate and the inflation rate.  Whether an interest rate is high or low depends entirely on how it stacks up relative to the rate of inflation.  Think of it this way.  A 10% interest rate most of the time would be regarded as punishingly high.  But in the late 1970’s when the inflation rate was 12%, a 10% rate was actually quite cheap.  An investor could borrow at 10% for a year, buy an asset whose price would rise 12%, then pay back the 10% loan a year later and actually make money on the transaction.  So whether rates are high or low really depends upon their relationship to the rate of inflation.

The difference between the funds rate and the inflation rate is known as the “real” funds rate. Over the past 30 years, the funds rate has averaged 1.0% higher than the inflation rate.  As shown below, sometimes it will be higher than that, other times it will be lower.  But over time the “real” funds rate has averaged 1.0%.  Hence, the Fed would probably regard such a “real” funds rate as relatively “neutral”.  So if the Fed wants an inflation rate of 2%, and believes that its policy is neutral when the funds rate is 1.0% higher than that, then by implication a 3.0% funds rate in today’s world would be roughly “neutral”.

But the funds rate today is not at 3.0%, it is 2.2%.  Thus, the Fed has a ways to go.  The Fed expects to raise the funds rate three times to the 3.0%mark by the end of next year.

The U.S. economy has never dipped into recession until the Fed has pushed the funds rate higher than the so-called “neutral” rate.   In fact, as shown above, it had to raise the funds rate to 6.5% in 2000 and 5.25% in 2007 before the economy spiraled into recession.  If the funds rate is 3.0% by the end of 2019 there is virtually no chance that such a level would be the catalyst for a recession.

Stephen Slifer

NumberNomics

Charleston, SC


Treasury Notes — 10-Year Maturity

December 3, 2018

The yield on the 10-year note has risen sharply in recent months as the economy has gathered momentum and market  participants fear a quickening in the rate of inflation.  When the 10-year hit the 3.0% mark the stock market panicked because long rates have not been at that level since 2013.  But the reality is that a 3.0% rate on the 10-year is still low.

During the past several business cycles the 10-year note has averaged 2.2% higher than the inflation rate.  With the yield on the 10-year note today at 3.0% and inflation at 2.4%, the real 10-year rate is 0.6% which is very low by any historical standard.

If the Fed keeps the inflation rate at its 2.0% target and the rate on the 10-year tends to average 2.2% higher than that, the yield on the 10-year should eventually reach 4.2%.  While the markets have gotten jittery because bond yields have risen to the 3.0% mark the reality is that long rates are going higher in the months and years ahead.  But even a 4.2% rate should not stall the expansion.

When will rates have risen high enough that the economy could dip into recession?  The yield curve — which is the difference between long-term interest rates and short rates — will give us a hint.

With the 10-year yield at 3.0% and the funds rate at 2.2%, the yield curve today has a positive slope of 0.8%.  When the Fed tightens aggressively short rates will move higher than long rates and the yield curve will “invert”.  When it does that is almost invariably a sign that the economy is about to dip into recession.  Note how in both 2000 and 2007 the curve inverted by 0.5% or so six months to one year prior to the onset of recession.  If the Fed does what it intends to do and pushes the funds rate to 3.0% by the end of 2019 and bond yields at that time are 3.6%, the curve will still have a positive slope of 0.6%.  Not a problem.

If the world evolves as described above, the funds rate will be at its neutral level by the end of 2019 but it is not anywhere close to the danger level of 5.0%.  Bond yields will presumably be 3.6% which and the yield curve will have a positive slope of 0.6%.  A year from now there may still be no sign of an impending recession.

Things could go wrong, of course.  The economy could suddenly grow very quickly, and/or inflation could climb significantly above the Fed’s 2.0% target.  Either of those situations would push the funds rate sharply higher than expected and make the yield curve invert.  For us to make a recession call we need to see two things — the funds rate will need to be well above the neutral rate (probably 5.0% or higher), and the yield curve should be inverted.  Neither of those conditions seem likely to be met by the end of 2019.

Stephen Slifer

NumberNomics

Charleston, SC