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This week, the Federal Reserve raised interest rates for the first time since the start of the pandemic—and financial conditions are continuing to tighten. The decision to raise interest rates was expected on the heels of a strong economic recovery and rising inflation throughout most of 2021. Still, it remains an important change—target interest rates have not been meaningfully above 0% since March 2020 and have only remained meaningfully above 0% for 4 of the last 14 years.
Financial conditions were tightening across the board since the start of this year as the Federal Reserve signaled less accommodative policy moving forward. The spreads on corporate debt are increasing, high yield corporate debt issuance is decreasing, and the Treasury yield curve has been flattening. In some cases, financial conditions are meaningfully tighter than they were before the pandemic—a sign of how hard Jerome Powell is willing to push in order to get inflation under control.
Still, forecasts from the Federal Reserve and pricing from futures markets expect short term interest rates to only reach about 2% by years end—which is close to the “terminal” long run rate of about 2.5-3%. Remarkably, despite the rapid recovery and high inflation, nominal interest rates are not expected to reach their 2018 highs until mid-2023 and are never expected to reach their 2007 levels. That is because the structural factors keeping real interest rates low—primarily low population growth, high wealth and income inequality, and low productivity growth—are not expected to end anytime soon. The Federal Reserve therefore is managing this rate hike cycle more nimbly than previous cycles—with an eye to these structural factors and the conditions in financial markets.
Monetary policy is sometimes said to operate with “long and variable lags.” While it is true that it takes some time for changes in Federal Reserve policy to show up in inflation and employment data, it is not true to say that policy itself takes a long time to affect the economy. Changes in current or expected future monetary policy have immediate effects on financial markets, and changes in financial markets have near-immediate effects on business and investor decisionmaking. It is changes in this decisionmaking that often take some time to show up as meaningful changes in broader economic conditions (inflation/employment/fixed investment/etc). Since the start of 2022, financial conditions have been tightening significantly as measured by the Federal Reserve Bank of Chicago’s National Financial Conditions Index. Credit conditions in particular were about to become tighter than their long run average—even before the Federal Reserve began raising interest rates officially. The signal of tighter monetary policy was enough.
Yield spreads on corporate debt—the difference between the yield on relevant corporate bonds and risk-free treasury bonds—have also been rising since January. Corporate spreads are a good proxy for how difficult it is for large companies to borrow money, and they tend to therefore be an early indicator for the relative tightness of monetary policy. As of right now spreads are at approximately late-2018 levels—right when Jerome Powell backed off the Fed’s previous hiking cycle amid fears of a weakening economy.
High yield corporate bond spreads—that is, the spreads on bonds issued by companies with high default risk—have also been increasing significantly since the start of the year. Given that ICA/BofA’s measure of high yield spreads hit all-time lows in mid-2021, it is possible that the creation of the Federal Reserve’s corporate credit facilities early in 2020 lowered the baseline risk of high-yield bonds. In other words, the Fed’s actions put a perceived backstop on the junk bond market and investors may expect the Fed to be more likely to backstop junk bonds in a future crisis. Nevertheless, tightening monetary policy is currently raising junk bond spreads today.
These tightening financial conditions are making it more difficult for firms to borrow money—and as a result corporate debt issuance has decreased. In February total corporate bond issuance was down 40% from 2021, and issuance of high-yield bonds was down a staggering 75%. Some of this is admittedly a return to normalcy—bond issuance was relatively high in 2020 and 2021 due to refinancing activity, looser monetary policy, and high demand for debt as firms attempted to navigate the pandemic. Still, tightening financial conditions and rising geopolitical risks have lead many firms (especially firms issuing high yield debt) to put off their borrowing plans.
The yield curve is also steepening as the Federal Reserve raises short term interest rates. In other words, yields on shorter-term government debt are rising faster than yields on longer-term government debt—a sign that investors expect nominal rates to increase quickly in the short term and then stop increasing soon after. Today, Real 10 and 30 year Treasury yields are still negative and near all time lows. In recent weeks real rates have declined while inflation expectations rose thanks to the negative economic fallout of the Russian invasion of Ukraine—though both real rates and inflation expectations have normalized a bit since then. Now, real interest rates must be analyzed with caution (after all, real interest rates are kept artificially high when tight policy keeps inflation and growth low as in Japan), but low real interest rates are generally a sign that expectations for real economic growth are weak—among other structural factors at play. And the structural factors keeping rates low in the US show no signs of alleviating.
How High Can Rates Go?
In the Federal Reserve’s last hiking cycle, monetary policymakers were not able to push their main policy rates (in this case the interest on excess reserves (IOER) later renamed interest on reserve balances (IORB)) to 2.5% before they were forced to back off. Even before the pandemic, Jerome Powell was attempting to lower interest rates in order to further stimulate the economy—going nearly as far as to call the 2018 rate hike a mistake. What’s remarkable is that nominal interest rates in 2018 were extremely low by historical standards—lower than at any point between 1962 and 2000 and far lower than the above-5% interest rates of the 2007 hiking cycle.
Nominal bond yields have been on a more consistent decline for basically the last 40 years. A lot of that is due to lower inflation and lower inflation expectations, but real interest rates have also been declining significantly. Official data only starts in 2005, but the fact that nominal rates were declining faster than inflation suggests a longer-run decline in interest rates. What structural factors underpin the long run drop in real interest rates?
First, I would emphasize the role that the 2001 and 2008 recessions have had on real GDP per capita growth. In both recessions—but especially the global financial crisis—the policy response was not strong enough to restore full employment and return to pre-recession output or growth levels. The drop in output and expected output growth lowers real interest rates as firms and households have less desire to borrow or invest. This also contributed to a safe asset shortage as the increased economic risk and lack of suitable alternative investments raised demand for safe assets like government bonds.
The good news on this front is that the Federal Reserve seems dead set on not reliving the mistakes of the last two decades. Private investment—alongside employment, output, and growth—has bounced back much stronger this recession than in either 2001 or 2008. Longer run productivity issues—like the housing, healthcare, and climate crises—will still likely keep GDP per capita growth artificially low, but the impact will not be as large as the impact of the 2008 recession.
The second major structural factor is the drop in working age population growth in the US. Birth rates have been declining across the globe for decades, and America in particular has experienced a slowdown in net immigration over the last few years. Decreasing population growth reduces the need for capital investments to build capacity to provide for future generations. In the most obvious example, fewer homes are needed for given level of real GDP per capita growth if fewer people are born. On a more basic level, younger people have a higher demand for borrowing (first-time homebuyers need mortgages) and older people have a higher demand for saving (retirees need a nest egg)—so the aging of the general population tends to lower real interest rates.
Thanks to immigration, America’s population growth is not that bad from a global perspective—South Korea is expected to see a 40% decline in its working age population by 2060 compared to a 10% rise in the US. But if global population growth is expected to stay low, open capital markets mean that the US cannot simply avoid low real interest rates. The bad news on this front is that the pandemic has (understandably) decreased birth rates in the US and across the world.
The final major structural factor is rising wealth and income inequality. Wealthier households—especially ultra-wealthy households—save a much larger share of their income than middle and lower-income households. Over the last few decades, the share of total income going to America’s wealthiest people has increased significantly. Since these wealthy households save a much larger share of their income, they have accumulated a larger share of America’s total assets. Their increased saving then puts significant downward pressure on real interest rates. The most recent estimates are that wealth inequality has increased significantly since the start of the pandemic, though income inequality has marginally decreased. This is likely due to rising asset values increasing wealth inequality while government stimulus and a tighter labor market decrease income inequality. All of these structural factors help explain the low expectations for long run real interest rates.
Jerome Powell has sounded a more hawkish tone over the last few months—but has promised to remain nimble and respond to changing economic conditions. That means keeping an eye on shifting financial conditions while attempting to toe the line between tightening policy in order to achieve target inflation while not overly impairing economic growth.
Still, this is not the Federal Reserve of 1979—or even 2018. The attitudes in the Federal Open Market Committee’s (FOMC) Summary of Economic Projections are much more hawkish than in prior moths, but are not extreme. FOMC members expect GDP growth to be above trend, unemployment to be below 4%, and real interest rates to be below their pre-pandemic level—all while inflation comes down to 4% in 2022 and 2.6% in 2023. This Federal Reserve is more aware of the risks of tightening too quickly and is setting monetary policy accordingly.
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