Money Is Still Free

Real interest rates are still negative, they are way below the rate of inflation.  The last Consumer Price Index (CPI) inflation reading in August was about 8.3%. The current Fed funds rate is about 2.5%.  The current two- year Treasury bond rate is about 4.1%.  The ten-year rate is about 3.75%.  None of the interest rates is nearly as high as the inflation rate.  Many people think the inflation rate is dropping, but even if it has dropped to around 6%, it is still about 2% higher than interest rates.  So, money is still on sale.    

Interest rates have been about zero, and mortgages have been about 3%, but house prices were not going up fast until the pandemic, when they skyrocketed.  If house prices, or other asset prices, increased at a normal rate, the asset price would only go up by about the same amount as the interest rate, about 3%. Of course, the stock market was booming through much of this time, except for the beginning of the Covid pandemic.  In any case, the interest rate, almost zero for big borrowers or a few percent for normal people, was well below the rate of asset appreciation.  That continues today, despite the Fed’s rate increases. 

Now, instead of zero interest, we have 3% or 4% interest, but asset appreciation at 8% or 9% is well above that rate.  Real interest rates are still below zero, although nominal interest rates have gone up.  The economy is out of whack.  Real interest rates should be above zero. 

The Fed should keep increasing interest rates until they are higher than the rate of inflation.  They say they intend to, but Wall Street now thinks the Fed should stop periodically to check the inflation rate, so that interest rates do not get ahead of inflation.  If inflation rates do not slow down, this means that the Fed will continue to maintain a negative real interest rate, which is an enormous gift to investors. 

After the “great recession” of 2008, the Fed embarked on a plan of keeping rates low by buying up trillions of dollars’ worth of bonds, thus keeping interest rates low.  In essence it destroyed the bond market, because the Fed was always buying bonds.  In a normal economy, if there are not customers buying bonds, the interest rate goes up to encourage people to buy bonds.  If a company needs to raise money, they have to offer bonds with a rate that will make people buy them.  But if the Fed will buy anything and everything, there is no reason to offer higher interest.  This has been called quantitative easing, or QE. 

As part of the Fed’s new fight against inflation, it has introduced quantitative tightening, in which it will wind down or sell off its enormous bond holdings.  This will operate in tandem with its raising interest rates the old-fashioned way.  Since QE is relatively new, being used in earnest only after the 2008 recession, QT if even newer.  Janet Yellen tried it in 2017, when it appeared to contribute to a significant stock market fall and was discontinued.  So, we do not have a lot of data on what it likely to happen when the Fed tries it this year. 

The Fed held about $9 trillion of Treasury bonds and mortgage-backed securities on June 1.  It planned to reduce its holdings by $47.5 billion per month for three months, and then to increase reductions to $95 billion per month.  It remains to be seen how interest rate increases and QT work together. 

The one recent example we have was in the UK, where the new government’s economic plan of reducing some taxes led to a run on bonds (“gilts” in Britain), which forced the Bank of England (the British Fed) to step in and buy bonds as it and the Fed had done under QE, in essence a reversal of QT.  QE has been used to increase liquidity, to grease the bond market, in times of economic difficulty.  Could QT create the reverse condition and create market difficulties by removing liquidity?  We may find out by trial and error.  QT might end up being a greater threat to market stability than interest rate increases.