Thursday, 19 of April of 2018

Economics. Explained.  

Category » Interest Rates

Fed Funds Rate

January 4, 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 is that 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 0.1.25%.  Thus, the Fed has a long ways to go.  In the old days the Fed would tighten by 1/4% every time it meets which is every six weeks.  This time, however, the Fed has indicated that intends to raise the funds rate at an even slower pace or, probably, about 1/4% every other time it meets which would be every 12 weeks.  If it tightens at this new super-slow pace it will take until mid-2020 for the funds rate to climb to the 3.0% mark.

The U.S. economy has never dipped into recession until the Fed has pushed the funds rate higher than the so-called “neutral” rate.   If that is the case, it is hard to imagine how the next recession will occur prior to 2020.

Stephen Slifer

NumberNomics

Charleston, SC


Mortgage Rate

January 4, 2018

Right after the election in November of last year 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.  They have since retreated slightly to the 4.0% mark.

If the Fed raises rates three times in 2018 to 2.0% and the core inflation rate climbs from 1.7% today to 2.2% by yearend, the 30-year mortgage rate is probably going to end 2018 at about 4.5%.

Stephen Slifer

NumberNomics

Charleston, SC


Treasury Notes — 10-Year Maturity

January 4, 2018

The yield on the 10-year note backed up dramatically following the election in November of last year as market participants feared that Trump’s tax cuts and the repatriation of funds currently held overseas could push the inflation rate  higher and force the Fed to tighten more quickly than it currently anticipates.   The rate rose from 1.7% right before the election to 2.6%.  It has since fallen back to 2,4%

The question arises, what is an appropriate level for the 10-year note?   The answer to that question lies in something called the “yield curve” which is nothing more than the difference between long-term interest rate and short rates.  Today the 10-year note is 2.4%, the funds rate (an overnight rate) is 1.25%, so the difference between long rates and short rates, or the yield curve, is 1.15%.  Historically, the yield curve has averaged 1.65%.  However,  the steepness of the curve varies depending upon whether the Fed is tightening or easing.

When the Fed tightens it raises short-term rates (i.e., the funds rate) much more rapidly than long-term interest rates rise, the yield curve “flattens” and can even invert.  When it inverts it means that short rates are higher than long rates, and the spread is negative.  Frequently an inverted yield curve can be a sign that the Fed has raised rates high enough that a recession might not be too far down the road.   You can easily see how the curve flattens, and even inverts when the Fed is in tightening mode.  That is not the case today nor will it be the case for several more years.

When the Fed eases they lower short rates (the funds rate) much more quickly than long-term interest rates decline and the yield curve “steepens”.  The steepening of the curve when the Fed is in aggressive easing mode can be seen easily.

The curve is not actually “tightening” right now, but it is trying to be less easy than it was previously.  The funds rate has climbed from 0.0% to 1.25%.  In  that period of time the yield on the 10-year note has fallen from 2.6% to 2.4%.  Thus, the yield curve has flattened from 2.6% (2.5% – 0.0%) to 1.15% (2.4% – 1.25%).

Between now and yearend the Fed should raise the funds rate from 1.25% to 2.0%.  At the same time the core inflation rate should climb from 1.7% today to 2.2%.  This combination of events should raise the yield on the 10-year note to 2.9% by the end of the year. Thus, the yield curve should flatten a bit further from 1.15% today to 0.9% (2.9% – 2.0%).  It does not appear to be in any danger of inverting between now and the end of 2018.  Thus, there is no danger of the economy slipping into recession between now and then.

Stephen Slifer

NumberNomics

Charleston, SC