Rising Rates Tie Ivory-Tower Types in Knots
There comes a time in every business cycle when market interest rates start to rise, well ahead of any official signal from the Federal Reserve. The onset of higher rates may precede the Fed’s first move by a few months, as it did in 1993, or by as much as a year, as in 2003.
The response from the economics community is invariably the same: Higher long-term rates are going to slow growth and put the expansion at risk.
So is mine: Not so fast. Just follow that line of thinking to its logical conclusion. Higher market rates slow the economy, which brings rates down, which boosts economic growth and generates higher yields. In other words, higher rates cause lower rates, and lower rates cause higher rates. With that kind of a closed feedback loop, how does an economy ever gain traction? And to think such circular logic carefully avoids any mention of the role of that ultimate supplier of credit, the central bank.
Prices -- interest rates are the price of credit -- are affected by changes in both supply and demand, with different implications. You can’t look at a price in isolation and determine the effect it will have on the quantity demanded, which is represented on the horizontal axis. (See graph.) This is one of the most important lessons microeconomics teaches and macroeconomists forget.
As far as I can tell, Fed Chairman Ben Bernanke has only intimated his intention to wind down quantitative easing. The slow march to normalize the benchmark rate, which has been at 0 percent to 0.25 percent since December 2008, is a long way off. The majority of the Fed’s Open Market Committee expects the first rate increase in 2015. The increase in market rates since the beginning of May has been anticipatory. Should the Fed fail to deliver -- or if markets perceive that conditions don’t warrant a relaxation of QE -- market rates will fall.
In all likelihood, they won’t return to the modern-era low of 1.38 percent on the 10-year note in July 2012 or even the 1.62 percent from early May. And that’s a good thing. The U.S. economy is gradually improving, with housing finally contributing to growth. The Fed has signaled that if all goes according to plan -- if the economy and labor market continue improving -- it will begin to taper its long-term asset purchases later this year and wind down the program by mid-2014, when the unemployment rate should be about 7 percent.
Fed tapering is contingent on a stronger economy. A stronger economy augurs increased demand for credit, which pushes up the price. The demand curve shifts out, which means a higher price and a higher quantity demanded, not a reduction as most economists claim. They confuse a shift in the demand curve with a movement along it.
That’s not all. Real, or inflation-adjusted, yields are rising, which is usually associated with stronger growth. The trend isn’t confined to the U.S. Several economists have pointed to the rise in real yields globally, suggesting it’s more than the Fed, or what Bernanke said or didn’t say, that is driving the increase.
Which brings us back to our economics lesson. Is the price of credit rising because the Fed has cut back on the supply? The Fed’s balance sheet stands at $3.5 trillion and growing. Although more than half the reserves created by QE sit in commercial banks’ accounts at the Fed, there has been no constraint in the supply of credit.
That means the higher price must be coming from the demand side. If investors expect the economy to be strong enough for the Fed to end QE and raise the overnight rate, that’s a plus. Both the path of short-term rates and long-term rates “are tied to the economic outlook, not divorced from it,” says Michael Darda, chief economist at MKM Partners in Stamford, Connecticut.
The confusion over long-term rates goes hand in hand with misconceptions about a steeper yield curve, which is a leading economic indicator and harbinger of stronger growth. A wider spread between banks’ borrowing and lending rates provides an incentive to increase their assets and expand the money supply.
It’s been 10 years since I wrote a column on this very same subject. I could have gotten away with changing the dates and updating the prices because the storyline hasn’t changed.
Back in July 2003, the first increase in the fed funds rate was still 11 months away. Long rates had started to rise, producing an outcry that -- you guessed it -- higher yields were going “to nip the nascent recovery in the bud,” to quote myself.
By the time the Fed raised the funds rate from 1 percent to 1.25 percent on June 30, 2004, the 10-year Treasury yield had already risen 160 basis points. The spread between the overnight rate and the yield on the 10-year Treasury note was about 375 basis points, close to a record. The same was true in the early 1990s, right before the economy took off.
If history is any guide, we should accept the modest rise in long-term rates to date and hope for more.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist.)
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