Markets are profoundly convinced the output gap is/was huge.
This is true in financial markets, which aren't dumping everything yielding less than 8%. It's true in the real economy, where inventories are being spun down [1]. It's true according to CBO [2] for the time period in which that eight percent registered. (Inflation was 7.9% February 2021 to '22. The CBO output gap was, in Q1 2021, roughly where it was in Q1 2003. After 9/11 and the dot-com crash.)
Side note: this is probably the smartest question on this page.
My takeaways are that:
a.) Interest rates are going way up from here.
b.) Even if the Fed moves to where the dot-plots are projecting - about 3% in 2024 - it is way too little to contain inflation. I think their assumption is that inflation will come down on its own as supply-chain issues abate, but I don't share that assumption with the Fed.
OP's equation for the Taylor Rule is...unorthodox [1]. For those who don't want to calculate equilibrium real interest rates and take logarithms of linear trends of GDPs, the Fed has a heat map tool [2].
It says 7 to 9%, using defaults. Higher than 3%. But within the model's error bars. (All that said, I have more confidence in inflation being manageable than rates remaining below 3%. Trading on that hunch, however, would require fighting the Fed. You don't fight the Fed.)
[1] https://en.wikipedia.org/wiki/Taylor_rule#As_an_equation
Side question: how do we calculate that correlation? To clarify, I understand that you can take two sets of observations and calculate rho, etc.
What I'm really curious about is how (or whether) the correlation is adjusted. Suppose there is always some kind of base inflation that doesn't correlate with interest rates; do we have a sense for what the additive effect of changing interest rates does?
Sorry to clarify - you can run any correlation on those two lines (wither lagged or not) and you'll find very little direct relationship, but the more important point is:
By saying interest rates and inflation are not correlated, I meant that both inflation and interest rates were declining to historic lows, which is in direct opposition to the theory that 'raising interest rates reduced inflation.' As you can see on this chart, interest rates aren't even that much lower than they were in the period where we were worried we'd never see inflation ever again.
My main gripe with the current narrative around inflation is 'does it really seem logical that moving from 2.5% to 1.0% 10Y yields is what caused inflation (when going from 7.5% to 2.% had no effect), given all we know about how broken our supply chains have become?'
Edit to change QT to QE
2) My gripe with the stimulus argument is 'why is inflation accelerating 12 months after we stopped'? For example, are used cars (a major contributor to current inflation) really going up in price b/c people can afford to pay higher prices, or is it because we are making way fewer new cars? Same story for houses (given that we've chosen to abandon billions of sqft of office space and replace that with at-home offices).
Sure, loose money support isn't helping inflation, but the idea that the solution to our current inflation problem is to decrease demand seems unthoughtful, given the fact that we know we are producing well below our potential (on a global scale).
I actually don't disagree with you that inflation will go down in the next 12 months, but I think it will primarily be on the supply side. At least I hope so.
Okay, these are all demand issues, and you point to the concomitant supply issues as well. And I agree. The supply issues certainly make it worse.
But here's where we disagree and I encourage you to answer this question:
Are cars/gas/consumer goods/food going up in price because consumers can afford to pay more for them (demand-side) or is it because we are making less of that stuff? I agree it's both, but it appears to be supply WAY more than demand (given how loose monetary policy has been for 20+ years and how unprecedented this supply shock is)
I tend to agree for some portion of inflation, but it's hard to tell because consumers paid down a lot of debt, refinanced their houses, student loans pause. So even without new fiscal stimulus, consumer spending power will remain elevated. Labor market is also tighter than anytime in history, which would logically lead to a wage price spiral.
Credit card debt is rising quickly though.
And finally, the most consequential rates for the economy are longer term rates, which are more market driven, not the overnight rate.
But if 10y treasury rises to even 3.5-4%, all asset valuations will implode, for the most part. Fed have backed themselves into a corner by waiting far, far too long to take any policy action. Pretty gross negligence of their duties IMO, when warning signs have been blaring for close to a year
This will go down as one of the biggest policy mistakes in Fed history.
The Fed largely caused the 2008 crisis by underestimating the effects of falling house prices on bank solvency.
What's crazy is that all I hear about in the financial press is how the Fed saved the economy after 2008. Conveniently omitted is that their miscalculations also caused the crash.
Whenever the Fed talks about finding a soft landing, I get nervous.
Of course there were many other factors too, government policy encouraging and guaranteeing subprime mortgages, clueless borrowers, faulty credit assessments, too much leverage.
IMO the government should seek not to create bubbles and also to set up a structure where it's inherently difficult for them to form. E.g. Limiting leverage for investors/important institutions is an obvious one. A system that relies on participants making smart decisions is doomed to fail in the long run.
If buy and hold residential SFH investors were only allowed to lever up to 2x to 1, you would see significantly less speculation in SFH with minimal downside outside of investment returns for those investors.
It really doesn't take a lot to set up a safe structure while still leaving it a mostly free market. Just requires foresight and a willingness to curb some of the fun/exuberance in the short run
https://fred.stlouisfed.org/series/FEDFUNDS
If 2002-2004 was keeping rates too low then what do you call the past 14 years?
To his credit he did start ratcheting it up shortly after.
Low rate from past decade is for many reasons, high unemployment for most of the 2010s is the main one. Weak fiscal response to 2008 leading to slow recovery.
The Fed shouldn't be the tool to try to address impact of a recession, it's much healthier to address through an intelligently crafted fiscal package. But the ease of being able to unilaterally set monetary policy tends to corrupt the Fed's decision making and skew it towards short term problems.
All that being said, Greenspan did a hell of a better job than Powell overall
Really, when you raise the interest rate, the only difference is that some of the money is now going to the bank instead of the landlord. It doesn't make housing more or less affordable as affordability is driven by supply and demand.
100 houses and 200 people => affordability goes down, 200 houses, 100 people => affordability goes up.
By the way, I didn't say prices because affordability can be independent of prices. If you can borrow more from a bank, you still have to outcompete the next best bidder who also gets more money so borrowing more money doesn't make it easier to obtain a house in a popular location. Okay, I oversimplified it a bit, lower interest rates do make it more affordable to live in unpopular locations as some houses are going to be empty and thus very cheap regardless of the interest rate.
This whole thing about betting on higher and higher house prices is just sick. Make houses and its land lose their value over time, that's the only way out.
As of February, 2022 the 10y has been rising at 0.1% _per week_, so 4% in the next 3 years seems pretty optimistic.
Buying a house now has more risk than anytime since the mid 2000s. Though many would surely dispute. Don't need to get into all the stats, but the interpretation of the stats being used to drive the FOMO narrative is a result of stats crime and misunderstanding
There comes a level with long bonds where indebted companies start to fail, and it's not very high. This will cap the 10y from going too excessively high, as bond traders are pretty smart and will buy when they think we're near the cap.
Personally I think zombie companies should be allowed to fail. Kinda like forest management for the economy. It's the better alternative to carrying non viable businesses into perpetuity. The Fed has erred on the side of bailing out speculators far too heavily... creates big moral hazard
never gonna happen. I would say there are greater odds of the stock market making new lows this year than that happening
>Buying a house now has more risk than anytime since the mid 2000s. Though many would surely dispute. Don't need to get into all the stats, but the interpretation of the stats being used to drive the FOMO narrative is a result of stats crime and misunderstanding
People say this all the time yet real estate keeps doing well.
> The Fed has erred on the side of bailing out speculators far too heavily... creates big moral hazard
Still I'd rather not be fighting the fed. Stocks and real estate prices will likely go much higher.
And the 10y is far below where it will likely settle. So 5-5.5% mortgage is pretty much a given within the next few months barring a sudden collapse in inflation
Buying a house is fighting the fed now. They are trying to quell inflation and will very likely start selling MBS into the market next month to push mortgages rates even higher.
Don't fight the fed works both ways. And don't even look at the inflation adjusted home price chart... Hint, they are far above the 2000s peak
Doesn't a tightening environment drive down prices (favoring the buyer today) and open the prospect of refinancing next time the fed chickens out (favoring the buyer tomorrow)?
"Oh, high prices, I have just the cure: debt!" is usually a sales gimmick, not something that favors the buyer. What am I missing?
It's true that price will move inversely to rate (all else equal), but price effect lags the rate change.
If rates stay at 5% or above we can expect prices to likely start to slowly decline in many areas.
It took 5 years for prices to bottom in the 2000s. Housing is a slow moving market
They didn't even blink as housing rallied at the fastest pace in history as they continued to buy MBS month after month, artificially pushing mortgage rates lower.
Hard to argue they cared at all about overdoing it, or distorting unviable companies towards profitability.
This kind of policy approach steals wealth from future generations to pay the present. It's basic math. Personally, I prefer policy makers that optimize for the long run, even when it makes the present a bit more challenging
Similar to 2000s, Bernanke raised too fast, but the raising should have started years earlier to prevent the need to move so fast
Otherwise we may very well end up in the 70s part two. There is not a good way out at this point unless the fiscal drag really is sufficient enough to cool inflation on its own. Which is really looking doubtful at this point.
A creative way out would be for the Fed to partner with fiscal policy to enact a new tax scheme or similar which sucks some of the money out without requiring higher rates. But chance of that happening is pretty much 0. It looks like the aim for the BBB has barely changed, and will still be inflationary the way it's proposed.
And keep in mind, long rates are market driven. If the Fed slow walk the rate increases, the 10y will just go up faster and faster as expectations of future inflation continue to go higher. There is no way to stop the repricing of the 10y at this point, aside from inflation coming down or more aggressive fed action to prove they are serious
Last year, if you bought 10-year bonds, they'd be something like 2% interest rate. Today, its 2.38%. This means that all 10-year bonds bought in 2021 (aka: today a 9-year bond) is 2%, or roughly $11,800 value remaining.
But a 10-year bond in 2022 is 2.38%, or roughly $12,380.
Relative to the 2021 bonds, you just "dropped the value" of 2021 bonds by $500-per-$10k or so. Literally, in the space of a few weeks, everyone who had 10-year-bonds from 2021 just __LOST__ money on the interest rate hike.
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Since banks and other large investors all own substantial amounts of bonds, the short-term effects of interest-rate changes on the _VALUE_ of bonds (ie: the 2021 issues) is arguably more important than the coupon itself.
If we're looking at +1% increase this year (to a 10Y rate of 3%), then a 10-year $10k bond 10Y @ 3% will have a Yield-to-Maturity value of $13000, meaning that the 2021-issues are worth something like 12% LESS.
EDIT: That's just the federal bond market. When you consider that car-loans, credit-cards, and Mortgages and HELOCs are also going to change in reaction to this (since these are higher-risk, a +1% chance to the "risk-free" federal rate probably will be a +1.5% to the other rates), the value of mortgages, credit card debt, car loans (etc. etc.) will similarly drop by 10%+.
Also consider what it will do to home prices. +1% interest rate to any mortgage will cause the monthly payments to skyrocket by hundreds of dollars, which will force home-prices down.
But consider that most banks, card companies, etc are more like retailers. They buy money at a certain price X (their funding costs) and sell it at Y (loan/card interest rates). As long as Y-X is positive, they're broadly OK.
The ultimate owners of these bonds are pensions, insurance, endowments, and other large actors who are basically price takers. They have huge piles of money to invest ($xx/xxx billion), and limits in how much risk they can take (e.g. only investment-grade debt) but beyond that, are looking for the best price offered given how much they need to invest, and matching the term (e.g. 5 years) to their portfolio needs. These people tend to hold bonds to maturity and just reinvest the proceeds when they mature. They don't sell them on the secondary market as much.
When those bonds are suddenly worth 5% or 10% less due to rapidly rising interest rates, on top of 7% inflation, they'll be pissed. In any case, you're basically causing the retirement funds of millions-of-Americans to suddenly decline in value.
This decline in value is arguably more important than the coupon value itself. That's all I'm trying to say. If you focus 100% on the coupon rate, you're ignoring the greater effects of the market.
This has been true for decades now. We are locked into a downward trend where 0% will ultimately be the norm. We will then decide what is more important, preserving sanity or going negative. The price of sanity will be pain like no one has ever experienced since the great depression.
5 + 0 + 0.5 (5-2) + 2
Atlanta Fed has a calculator https://www.atlantafed.org/cqer/research/taylor-rule
to the extent you think there is an output gap or you are willing to let inflation run hot for a bit due to COVID catchup because you think it's temporary, you can shade that down but it only gets you a couple percent. so the march 2022 Fed dot plot with rates maxing out around 3% seems pretty optimistic.
but if they posted a dot plot in line with Taylor rule, markets would crash, politicians would go nuts. so they are not going to do that, so they will keep tightening gradually and hope for the best. it's hard to see inflation cooling sufficiently without a recession. eventually at some point of course we will end up in one. the question is how long and how high inflation has to get. the political implications of a recession right now are a bit grim.
It also requires instantaneous measurement of its variables. These can be estimated in normal times but it's hard when there's been a recent anomaly. Is the 5.6% T4Q real growth the new normal or just the result of measuring out of a trough?
One view of monetary policy is that its ultimate goal should be to stabilize NGDP growth -- usually to something like 5%. Looking at the trailing 8 quarters since 2019-Q4, NGDP growth has been 5.2%. Remarkably good.
But there is some cause for concern. In my view: rising petroleum prices, QT, and further supply constraints from zero-Covid policy in China (in that order).
Also, even trading commodities futures, at the end of the day there are physical commodity limits. Production, storage, transportation, consumption.
You can't, for example, decide to invest the Chinese trade surplus in soybeans. Size mismatch. So you (at nation-scale) have to pick the least bad of the options available to you.
I'm guessing -- also not deeply versed in macroeconomics -- that "buy the basket of goods or gold or anything that holds its value in dollar terms" isn't actually that easy. For one, if everyone does that, you'd expect current prices of said goods to rise, and then fall when you try to sell them. Thus there's some risk that you'll essentially mis-time your transactions and buy high / sell low.
Two, there may be other reasons whatever you buy fails to hold its value. Someone might discover a giant gold deposit or whatnot, rocking the gold market.
Three, there are transaction costs. For property, you're paying realtors, home inspectors, closing costs, etc...
I'm sure this is an incomplete and naive analysis.
If you're going long on persistent inflation than go buy TIPS, I know I did as a hedge while the rest of my money is going into 1-year treasury bills because things are going to get crazy volatile as the fed funds rate continues to hike.
Buying housing in a rising rate environment is playing chicken, as rates go up affordability goes down and so does the value of the home. That's the fundamentals in a normal market, at least, because ultimately mortgage payments have to come from wages somehow. I wouldn't buy something banking on the crazy appreciation train continuing at this stage.
So central banks don't feel the urgency to raise interest levels above 8% and consequently the market interest rate doesn't get too high either.
8% was from data as of February.
By the way, shelter inflation is steadily climbing at 0.3% per month. That's going to be a fearsome trend to reverse.
Inflation is 8% or more. Interest rates are about 0.25%. How can we possibly tame inflation by (e.g.) raising them to 3% or 4%? At that level, it still makes sense to borrow all you can, buy the basket of goods or gold or anything that holds its value in dollar terms, sell it later on, and pay the loan back.
Put another way: the Taylor rule says that the optimal rate is
r = p + 0.5y + 0.5(p - 2) + 2
where p is inflation and y is the output gap. So for p = 8% we get r = 13% + 0.5y. Unless we're profoundly convinced that the output gap is absolutely huge, then our interest rate is ridiculously too low. Why does the Taylor rule not apply?