Wednesday, 22 of May of 2019

Economics. Explained.  

Category » Interest Rates

Fed Funds Rate

March 29, 2019

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”.  In more recent years the real funds rate has slipped a bit to 0.8%, thus the Fed now  believes that a neutral funds rate is about 2.8%.

But the funds rate today is not at 2.8%, it is 2.4%.  Thus, the Fed is still slightly below its assumed “neutral” rate.  At the same time the Fed has said it intends to leave the funds rate unchanged through the end of this 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.  We believe that at the 5.0% mark we should begin to pay attention for signs of a growth slowdown.  However, if the funds rate is 2.4% 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


Mortgage Rate

March 29, 2019

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 last year  boosted the 30-year mortgage rate to 4.9%.  But the Fed recently signaled that it intends to leave rates unchanged for the foreseeable future, the stock market decline in the fourth quarter created an expectation for slower growth ahead, and slower growth overseas, allowed long-term interest rates to decline quickly.  The 30-year mortgage rate dropped from 0.9% from 4.9% late last year to 4.0% currently.

If growth rebounds in the final three quarters of this year and inflation remains steady, it is likely that long-term interest rates will rise slightly as the year progresses.  We expect the 30-year mortgage rate to end the year at about 4.4%.

Stephen Slifer

NumberNomics

Charleston, SC


Treasury Notes — 10-Year Maturity

March 29, 2019

The yield on the 10-year note has fallen 0.9% in the past couple of months from 4.9% to 4.0% in part because the Fed said that it was done tightening and the funds rate would be unchanged for the foreseeable future.  At the same time the 20% correction in the fourth quarter of last year created an expectation for slower growth ahead.  And the inflation rate has edged lower in recent months instead of rising as had been anticipated.  As a result, all long-term interest rates have declined sharply.

During the past several business cycles the 10-year note has averaged 2.0% higher than the inflation rate.  With the yield on the 10-year note today at 2.4%% and inflation at 1.7%, the real 10-year rate is 0.7% which is very low by any historical standard.

If the Fed keeps the inflation target at 2.0%  and the rate on the 10-year tends to average 2.0% higher than that, the yield on the 10-year should eventually reach 4.0%.  However, it should not rise to that level for some time if the inflation rate remains relatively steady.  At the end of 2019 we expect the yield on the 10-year note to climb slightly  to 2.75%

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.   When the Fed tightens aggressively short rates typically 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.  Thus, an inverted yield curve is a closely watched indicator that a recession may be approaching because it tells us that Fed policy is “too tight”.  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.

Today, with the 10-year yield at 2.4% and the funds rate at 2.4%, the yield curve today is flat and some parts of the curve are slightly inverted.  However,  a curve that inverts because the Fed has raised short rates quickly and they eventually become higher than long rates is a danger signal because the inverted curve is a signal that Fed policy is “too tight”.  But in the recent case the curve has inverted slightly because long rates have fallen sharply and are now below short rates.  A curve that inverts because long rates have fallen sharply does not carry the same danger signal as when the curve inverts because short rates are rising rapidly.  There is a big difference.  The inverted curve today is not a harbinger of an impending recession

For us to make a recession call we need to see two things.  First, the funds rate will need to be well above the neutral rate (probably about 5.0%), 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