Is it real or nominal short-term interest rates that matter?
Rising nominal rates matter when they cause financial stress – borrowers who can’t service debt, loans called in because collateral values have fallen, lenders facing loan losses that erode their capital, etc.
Right now, that’s not happening – so it’s real rates that matter. Real rates have fallen very, very sharply across the yield curve in recent months. That’s true whether you use actual or expected inflation to calculate real rates – because inflation has been much faster than people thought it would be. Even if the Fed now accelerates to a 50 basis point hike every meeting, by year-end it’s likely to have done no more than partially nibble away at the recent collapse of real short rates into deeply negative territory.
Currently, it makes enormous sense to go out and spend, spend, spend, whether you are a consumer, a company building inventories, or even in many cases someone looking at physical investment. Whatever you are buying is set to get much more expensive in coming months, and you are so far from being compensated for that on your savings, or even your borrowing costs, that you better get out and spend before cash gets devalued.
Of course, the surge in energy and commodity prices that is starting to percolate into retail prices implies a squeeze on real incomes for many people. But for any consumers who’ve got savings, or access to credit, that doesn’t invalidate the argument that anything you can buy now will be cheaper than if they delay. Moreover, for energy-exporting countries like the US, this is essentially a distributional shock rather than a deflationary one. The Biden Administration already announced penal charges on energy companies with unexploited assets, and if enough policy signals of this type are given, the shock is spending-shifting, not spending-reducing. There is also scope for some direct help to consumers. Countries that are net energy importers can achieve similar results through government borrowing – EU plans to finance new energy infrastructure are an example.
The bottom line of the above is that the Fed is way behind the curve (and most other central banks even further). Unless they catch up, spending will be strong and inflation will stay high – until the monetary system crashes into major stress points.
But stress of that kind could be a long, long way ahead – after all, the entire structural reaction to the financial crisis of 2008-9 was to build in massive buffers to bank capital and elsewhere, and this regulatory sea-change has the effect of greatly diluting the relevance of nominal interest rates as compared to real ones.
So what about that yield curve? The combination of long years of central bank asset purchases, together with those regulatory changes, play a major role in distorting the signals from yields across the curve. No-one –let’s be honest about this – can really estimate how important these two effects are, because there just aren’t many data points. You can’t use daily, or monthly, or even annual data to gauge their importance, because bond markets are forward looking. All that’s really relevant are the small number of occasions on which a change to quantitative policies or regulations have been made, and there aren’t enough of those (especially since actions by different central banks and regulators are not truly independent).
So the inverting curves may signal recession, or they may reflect distortions, we don’t know (for what it’s worth, my personal view blames the distortion). But what we can be sure of is that they remain ultra-low against likely trend nominal GDP growth, and have recently fallen steeply relative to current inflation. So they remain highly stimulatory – supporting the major positive monetary stimulus coming from the fall in real short-term interest rates.
Quantitative Tightening, of course, will exert upward pressure on longer yields and gradually reduce this distortion. But gradually is the key word here. Moreover, since we can’t truly disentangle the effect of central bank asset transactions from the regulatory-induced demand for bonds, it’s very possible that the latter is by far the more potent force (noting that demand for shorter-dated bonds has ramifications right up the curve), and there are no plans whatsoever to dial that back.
The major decline in real interest rates is clearly a substantial buttress across the spectrum of risk assets, from equities to crypto. Of course, it cannot provide those assets with immunity from the effect of new adverse shocks as they unfold, but absent a drastic change of policy from central banks, it can provide an underlying bedrock of support.