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JOHN MASON: The Near-Term Future of Interest Rates

Former Federal Reserve Sr. Economist John Mason explores catalysts for yields on longer-term Treasury securities to rise

AUTHOR: John M. Mason

The Federal Reserve is expected to announce an increase in its policy rate of interest this week. The increase is expected to take the range of the Federal Funds rate to 1.50 percent to 1.75 percent.

The general expectation is that the Fed will raise its policy rate three more times this year and then follow that up with at least two increases in 2019.

That would bring the target range up to 2.75 percent to 3.00 percent by the end of 2019.

To put this into perspective, the yield on the 2-year US Treasury note is now trading just under 2.30 percent and the 10-year US Treasury note is now trading just under 2.85 percent.

Without any change in the longer-term yields, the yield curve in the United States would become very, very flat and many analysts are concerned with a flat yield curve because a flat yield curve, historically, is linked with an economic recession…something that no one really wants at this particular time.

The question then becomes, what might make the yields on longer-term Treasury securities rise?

The answer that comes to mind is that the US economy must heat up a little bit more.

One of the things that officials at the Federal Reserve seem to be counting upon is a rise in the rate of inflation.

Right now, the US inflation rate is running below the Fed’s policy target for inflation, which is a 2.00 percent annual rate of inflation.

The inflationary expectations built into the yield on the 10-year US Treasury notes are around 2.10 percent. This is derived from subtracting the yield on the 10-year US Treasury Inflation Protected securities (TIPs) for the nominal yield on the 10-year US Treasury note. (Roughly 2.85 percent minus 0.75 percent equals 2.10 percent.)

There are two factors that Fed officials have cited that could lead to increasing inflationary expectations. First, many at the Fed are counting on a rise in inflation due to the increases in energy prices over the past year or so. The feeling is that these increases have not been fully reflected in price indexes and so there is some catch up in inflation that needs to be captured.

The second factor is related to the budget deficits being created by the Trump administration with the passage of the tax-reform bill last December and the increase in the deficit caps earlier this year. Both are seen as resulting in further increases in prices in the next year or two.

But, whether or not these price increases come about is the big question.

Historically, increases in a country’s money stock have been the primary cause of rising prices. Most economists agree that the Federal Reserve has little influence over the longer-term rate of growth of the economy.

The Federal Reserve has certainly provided sufficient monetary resources since the end of the Great Recession to stimulate a more rapidly expanding economy…if, monetary policy could impact the longer-term rate of growth. However, the US economy has only achieved a 2.15 percent compound rate of growth over the past eight and one-half years of recovery.

The big question is that with compound rates of growth of 9.4 percent in the narrow measure of the money stock (M1) over the same period of time and a 6.1 percent in the broader measure (M2), why has the GDP price deflator increased at a compound rate of increase of 1.65 percent?

The answer is that the velocity of circulation of these money stock measures has fallen precipitously. Over the time period under review the velocity of circulation of the M1 money stock has fallen by 48.6 percent and the velocity of the M2 money stock has fallen by 27.8 percent.

These are “huge” declines and must be accounted for if we are to understand not only what has happened in the US economy, but also to comprehend what the Fed might be able to do going forward.

What has caused the velocity of money to decline to such an extent in the current period of economic recovery?

My answer has been that the financial engineering taking place within the US economy has come to dominate what is happening within the financial sector of the economy.

Just to give a hint of how financial engineering plays a role in this decline in the velocity of money, read what a recent survey conducted by Morgan Stanley has found with respect to how the benefits of the tax-reform bill are going to be used.

Morgan Stanley analysts estimated that 43 percent of corporate tax savings would go to buybacks and dividends and nearly 19 percent would help pay for mergers and acquisitions. Just 17 percent would be used for capital investment, and even a smaller share, 13 percent, would go toward bonuses and raises. Other Wall Street analysts have issued similar reports. If more evidence was needed, Axios reported that just nine pharmaceutical companies have announced $50 billion in buybacks since the tax law was passed.”

The monies being created by government policy are being financially engineered, thereby keeping most of the money in the financial circuit of the economy and not in the industrial circuit that would include such things as physical capital investment. This is how the velocity of circulation of the money stock declines in the face of attempts to stimulate the economy.

This process of financial engineering has grown over the past fifty-five years or so and has become more and more efficient and effective as governments have given the financial engineers the incentives to perfect their trade. Given the evidence, it must be the case that there is a greater return for a given risk in the financial circuit, than there is in the industrial circuit. Thus, we have asset price inflation and possibly asset bubbles, rather than the inflation in consumer or manufacturing prices.

Thus, the question becomes, will Fed officials get the inflation they are looking for…or not? Will yields on longer-term bonds rise…or not?

The other action taking place while this is going on is the effort the Fed is making to reduce the size of its securities portfolio. This effort has been going on since the end of September 2017. Looking at the Fed’s balance sheet, the Fed’s H.4.1 statistical release for March 15, 2018, we see that the Federal Reserve has reduced its securities portfolio by about $50.0 billion, but has actually increased the amount of excess reserves in the banking system. This has come about due to a reduction in the Fed’s use of reverse repurchase agreements, the main tool to reduce bank reserves over the past three years.

There are, however, very few reverse repos remaining in the Fed’s tool kit, so that further reductions in the securities portfolio should also result in a reduction in the excess reserves in the banking system. Further reductions, therefore, might put some upward pressure on market interest rates. We’ll see.