Viewpoint
October 11, 2024 | 15:08
October 11, 2024
Economics
Economics
Economics
Economics
Economics
Economics
Making Sense of Rising Interest Rates |
| Wait a minute, aren’t interest rates supposed to be falling? I can hear the question ringing in my ear. We all read numerous stories in the press shortly after the Fed cut rates last month about how this was going to lead to lower interest rates for everything from mortgages, auto loans, credit cards, and business loans. Eventually, this should all be true to some extent, but the problem is the fixed income market was already geared for a rapid normalization of monetary policy well before the Fed made its first move. Fixed income strategists were falling all over themselves to see who could factor in the most Fed rate cuts over the coming year since August. As early as August 9th, the Fed funds futures market was already pricing in 100 basis points of rate cuts by the end of 2024 and 211 basis points of cuts by the end of 2025. A dismal July Employment Report that sent the unemployment rate up to 4.3% and started a recession scare was the trigger. The larger than expected half-point rate cut from the Fed on September 18th to start the monetary easing cycle only solidified already aggressive expectations for rate cuts in 2024 and 2025. |
| On September 19th, a day after the FOMC’s 50 basis point rate decision, the rate cut expectations increased to 123 basis points by the end of 2024 as investors speculated on whether the Fed would do another 50 basis points in November and increased to around 248 basis points of cuts by the end of 2025. The Fed decision to “go big” in September also briefly fueled fears of a sharper downturn in the labor market that the July jobs report had started, and whispers grew that the Fed might know something the markets didn’t yet see. Ten-year Treasury yields and 30-year mortgage rates actually hit bottom a few days before the Fed rate cut in a classic buy the rumor and sell the fact fashion. Since then, Treasury yields with maturities of one-year or longer have only been going in one direction and that’s up. The 10-year Treasury yield has jumped nearly half a percentage point in less than a month (Chart 1), while the 30-year mortgage rate is up about 41 basis points over the period, hovering just below 7.0% today, according to bankrate.com. So, what’s been driving interest rates higher you ask? Stronger U.S. economic and labor market data is certainly a good place to start. Upwardly revised personal disposable income growth since 2019 took markets by surprise, improving the personal saving rate dramatically, and reducing the need for consumers to scale back their spending. The labor market looks healthier, too. The unemployment rate has been trending down since July and is now at a much less concerning 4.1%. Average hourly earnings growth is picking back up. On a three-month annualized basis, it is rising at a stout 4.3% pace with 6.6% earnings gains coming from professional and business services and 5.2% from information services (Chart 2). Recent Fed speak is also sounding a tad more cautious about the path for future rate cuts, signaling only gradual reductions from here. The Fed funds futures market, taking the hint, has scaled back rate cut expectations to around only 100 basis points for this year and another 100 basis points next year, about where the market was back on August 9th. The combination of a somewhat stronger growth outlook and fewer Fed rate cuts over the coming year has sent 10-year TIPs yields, a proxy for the real 10-year Treasury interest rate, 20 basis points higher, accounting for about 40% of the half a percentage point increase in the 10-year nominal Treasury yield. |
The other 60%, or 30 basis points of the move, is accounted for by rising inflation expectations (Chart 3). A disappointing September CPI report revealed uncomfortably elevated inflation in services, medical care, and food and beverages last month. In short, there has been plenty to drive somewhat higher longer-term interest rates from where we were. However, there does appear to be a limit to how high nominal interest rates can go from here with inflation forecast to gradually recede, labor market and growth cooling down, and the Fed continuing to gradually cut interest rates. We are likely close to that upper limit right now unless something drastically changes with the outlook. |
Inflation Déjà Vu? |
| On the surface, the inflation waters appear calm. Consumer prices rose 0.2% in September, chipping the annual rate down to 2.4%. But you don’t need to wade far to feel the undertow. Cheaper fuel tempered the rise but has since reversed higher. Grocery bills rose as much last month (0.4%) as in the prior seven. Unexpected strength in clothing and autos led to the first increase in core goods prices in seven months. Falling goods prices were providing a partial offset to the rising cost of services, until last month. Worse, services costs picked up, with the ‘supercore’ index leaping 0.4%, the most in five months. Core prices advanced 0.3% for a second month in a row, and not just because of a few special items. The Cleveland Fed’s trimmed-mean and median CPI indexes both climbed 0.3% as well. At a minimum, the data suggest the road back to price stability will remain bumpy, partly because overall consumer spending remains strong. Yet, a pathway back to 2% still exists. The peaks in recent core price increases have been lower than the string of three straight 0.4% gains that rang in the new year. Spikes in college tuition and doctor services fees last month likely won’t be repeated. A (belated) moderating trend in measured rent should continue amid ample apartment construction in recent years. Natural gas costs are low due to an abundance of supply, which will limit home heating costs this winter. Budget-constrained lower-income families have been pinched by higher living costs, compelling more companies to discount such items as appliances, furniture and toys to spur demand. Most importantly, despite large wage settlements for some unionized workers, labor cost increases have moderated, with the employment cost index slowing to 4.1% y/y in Q2, a more than two-year low. Meantime, growth in labor productivity shows little sign of fading. Given flat work hours and expected GDP growth above 2% in Q3, another solid productivity gain should help companies absorb wage increases with little hit to the bottom line and little urge to raise prices. |
| True, if core prices do pop again in October, we may need to start bailing. The November 5 elections could also usher in a boatload of new tariffs and even more stimulative fiscal policy, stirring the inflation waters. But if the economy settles down close to its long-run potential rate of around 2%—as the Fed forecasts for the next three years and is actively trying to achieve—then inflation should also settle down to 2% by early next year. |
Where Have You Gone, Fiscal Discipline?Government finances are in a tough spot, especially in the U.S., and there is little political will to fix them. This risks a market response. |
| As we enter the final month of the election campaign, there is one economic subject that neither candidate seems willing to address head on—how to deal with the bloated budget deficit. The CBO estimated this week that the deficit for the fiscal year that ended in September widened to $1.83 trillion, or roughly 6.5% of GDP, the third-largest gap on record after the two blowouts in the pandemic years of 2020 and 2021 (Chart 1). Instead, the focus has been on new measures that would, on net, actually raise the deficit—this at a time when the accumulated government debt held by the public is poised to break above 100% of GDP for the first time since 1946. The non-partisan Committee for a Responsible Federal Budget (CFRB) this week scored the announced proposals by the two candidates as significantly boosting the baseline deficit over the next ten years from $22 trillion—by $7.5 trillion under Trump, and by $3.5 trillion under Harris. We would emphasize that these estimates have a wide confidence band, and are based on only rough outlines of potential policy changes. But the key point is that neither is considering serious fiscal restraint. This lack of concern about the challenging fiscal landscape risks a market accident at some point—i.e., a bond market revolt, which could drive long-term yields higher. |
| The fundamental issue with federal finances is that revenues have been consistently below non-interest expenses ever since the budget was blown open by the Great Recession in 2008/09 (Chart 2). In the prior thirty years, the operating budget (i.e., ex-interest costs) had been in balance, on average, with the underlying surplus swelling as the economy recovered, and then dropping heavily when the economy fell into recession. But the balance never got back up after 2009. And this has been a bi-partisan issue—in stark terms, Republicans have cut taxes, but done little on spending, Democrats have lifted spending, but done little on taxes. On top of this deterioration in underlying finances, the big back-up in both nominal and real borrowing costs has driven the interest bill dramatically higher. In the latest fiscal year, spending on interest reached almost $900 billion, nearly exactly in line with both outlays on defense and on Medicare (Chart 3). In little more than two years, interest outlays have doubled amid the rise in yields and the underlying jump in the debt during the pandemic. Debt dynamics are not overly friendly, with the real 10-year yield now hovering just below 2%, compared with an average of just 0.4% in the decade prior to the pandemic. In those halcyon days, real borrowing costs were steadily below the U.S. economy’s long-run growth potential, which perhaps inspired the Modern Monetary Theory (MMT). Now we are faced with a much more sober reality of real interest rates at, or even a bit above, the economy’s long-run growth potential, a much more daunting backdrop. Of course, part of the reason why interest charges have spiked higher is not just the rise in market yields, but also the steep run-up in debt in recent years (Chart 4). There was a big step-up in debt/GDP in 2020/21 as the economy temporarily shut down and government spending rushed to fill the void—this was certainly not unique to U.S. finances. But, this followed the big step-up in debt during and after the Great Recession, which had already set finances on a challenging path. And, since then, there has been no net improvement in debt from the dire days of 2020/21. As a result, the debt held by the public has gone from a standing start of 35% of GDP as recently as 2007, to almost 100% now. As mentioned, this is the highest level since the aftermath of World War II—the difference is that the U.S. economy was poised to embark on a massive boom in the post-war years, and no such economic boom lies ahead. Thus, even with no major additional measures, the debt/GDP ratio is headed for a record high in the near future. There is no sugar-coating it—the U.S. faces a fiscal challenge in the years ahead. Between a near-record debt load, less favorable demographics, slower potential growth, and more normal real borrowing costs, there is a clear need for fiscal discipline. Some would assert that “deficits don’t matter”, and perhaps they don’t… until they do. In other words, one only really knows that government finances have weakened to the point where the market will say “enough”, when the market actually says “enough”—and by then, it’s too late. Two years ago, the U.K. mini-budget mini-crisis offered a stark example: 10-year gilt yields flared 250 bps in a matter of 7 weeks, which served as a warning to all others. While the U.S. is a very different credit, and unlikely to face the exact same challenges, it’s clear that the market can react suddenly and violently to unexpected fiscal weakness. No one wants the bond vigilantes to need to ride back into town. |
