Despite signals that the bond market thinks another rate cut is unnecessary, the Fed trimmed the fed funds rate by a quarter of a point to 1.75% at Tuesday’s FOMC meeting.
Since the last FOMC decision to drop the target rate by half a percentage point, ten-year Treasury rates have jumped by a full point. This is the first time in a long while that long-term rates increased following a Fed rate cut. Should this happen again after the latest meeting, it would surely signal to the central bank that its easing job is complete.
Fortunately, most of the recent bond market rate spike is accounted for by a jump in the real interest rate component of the market yield, not inflation expectations. Since early November the inflation-protected ten-year TIPS rate increased 66 basis points, or two-thirds of the nominal rate rise. The inflation forecasting TIPS spread rose by a modest 30 or so basis points and stands currently at only around 150 basis points — implying about 1% future inflation measured in terms of broad price indexes such as the personal spending deflator.
Decomposing bond rate movements is a useful exercise made possible by the relatively new TIPS market. Recent trends indicate that forward-looking bond yields are anticipating economic recovery next year. So the real interest rate, which can be viewed as the growth component of the market rate, is the active factor in the market rate rise.
Noteworthy is the fact that real interest rates tend to coincide with stock market moves. Rather than an obstacle to stock market gains, real interest rate increases are corroborating signals of the improving economic and profit outlook.
Also noteworthy is the fact that the current 3.5% ten-year TIPS rate implies market expectations that the economy can grow at its long-term, post-WWII trend of 3.5% adjusted for inflation. While this is still a full percentage point below the 4.5% ten-year TIPS yield peak registered at the height of the late-1990s technology boom, at least 3.5% is a good “natural” rate of economic growth.
This also might infer that future stock market gains will be capable of generating historic returns of 7% after inflation following the initial off-the-bottom recovery rise (which still most likely has 15% to 20% to go in terms of the S&P 500 index). Seven-percent real stock-market gains would fall well below the late 1990s pace, but that’s still respectable over the long-term.
Another bond-market signal that the Fed’s job is coming to a close is the positive 115 basis-point spread between two-year Treasuries and the fed funds rate. At a positive carry of over a percentage point, this differential implies adequate liquidity in the economy. That liquidity supplied by the central bank is now in rough balance with liquidity demanded in the economy is also illustrated by a bottoming in commodity indexes, a steady King dollar, and a stable gold price.
The Fed’s aggressive money-adding and rate-cutting operations after the September 11 war outbreak appears to have ended deflationary pressures in the economy. At this point, economic incentives to delay spending and investing decisions until interest rates bottom appear to have ended.
In fact, since forward-looking interest-rate markets are discounting somewhat higher interest rates next year, a new incentive may be developing where people will take economic action sooner in order to beat future rate increases. This incentive effect could generate stronger economic growth much sooner than consensus forecasters expect. Indeed, it is partly this logic that leads us to speculate on 2% to 3% economic growth in the first quarter of 2002.
Hopefully the Fed will pay careful attention to market price indicators in their future policy deliberations. If the central bank had paid attention to Treasury rates, commodities, and the dollar in early 2000, the deflationary recession of the past eighteen months could have been avoided. A price-rule approach over the next year will help deliver a solid, if unspectacular, non-inflationary economic growth recovery from recession. Continued price-rule adherence will sustain future non-inflationary growth at a much stronger pace than economic skeptics now believe possible.
Let’s keep our fingers crossed that the mistakes of the recent past will lead monetary policymakers toward the modern view that real-time market prices are better policy indicators than Phillips curves. Less Fed tinkering will lead to more economic growth and wealth creation.