Last week, the Federal Reserve raised its basic interest rate from 1 percent to 1.25 percent. In all likelihood, we can expect a similar move about every 6 weeks for the next year. Ironically, this will be bullish for financial markets in the long run.
The idea that Fed tightening can be bullish is counterintuitive. Grasping it requires an understanding of how long-term interest rates are set. Economic theory and experience tell us that the single largest component of long-term rates, such as those for home mortgages, is inflationary expectations. If markets expect 1 percent higher inflation, this will add approximately 1 percent to the long-term interest rate.
For the last several months, commodity and bond markets have clearly shown an expectation of rising inflation, which results when the Fed creates too much money. All commodity indexes are up sharply, as is the spread between long-term and short-term interest rates. Although there is little evidence of rising inflation in the consumer price index, experience shows that inflationary pressures show up first in sensitive commodity prices and an increase in long-term interest rates, and in the CPI only with a long lag.
Moreover, a key reason why the CPI is not showing more inflationary pressure is that the index excludes the most important area where prices are rising rapidly: housing. Over the last year, housing prices are up over 10 percent nationwide (18.6 percent in the Northeast), according to the National Association of Realtors, compared with a 3 percent increase in the CPI. The CPI uses a measure of rent in lieu of home prices, because this better represents the cost of housing to consumers. Using housing prices in the index would distort the cost of living because people don’t buy a new house every month.
But the result is that many people, including those at the Fed, may be misled into thinking that inflationary forces are more modest than they really are. For example, my old friends Jamie Galbraith and Jude Wanniski (an odd couple if ever there was one) recently co-authored an article imploring the Fed not to raise rates for this reason. But their argument really boils down to the same Keynesian hokum that got us into a mess in the 1970s — we can’t have inflation if there is high unemployment, unused capacity, etc. All this was disproved during that decade, when inflation and unemployment increased together.
The best indicators of inflationary pressure are not the money supply or the unemployment rate or the capacity utilization rate. They come directly from markets. These indicators are telling us that the Fed should have braked before now. As Dave Gitlitz of Trend Macrolytics notes, the price of gold — the best leading indicator of inflation — is up 50 percent from its lows and 20 percent above its long-run average, even though it is off recent highs. Given the lags, this suggests that we have not seen the worst of inflation despite the Fed’s belated move to tighten.
Unfortunately, if interest rates rise in coming months, many will automatically assume that it is because of the federal budget deficit. However, a new study shows that this is not a factor, despite conventional wisdom to the contrary.
It is authored by former Federal Reserve economist Eric Engen, now of the American Enterprise Institute, and R. Glenn Hubbard, dean of Columbia University’s business school and former chairman of the Council of Economic Advisers. In a paper for the prestigious National Bureau of Economic Research, they carefully review all the empirical and theoretical evidence regarding the impact of deficits on interest rates and find it to be far smaller than generally assumed.
Their conclusion: “Our empirical results suggest that an increase in federal government debt equivalent to one percent of (gross domestic product), all else equal, would be expected to increase the long-term real rate of interest by about three basis points.”
This is a trivial amount. One basis point is equal to one one-hundredth of a percentage point — equivalent to raising the rate on 10-year Treasury bonds from 4.6 percent to 4.63 percent. Just between Tuesday and Wednesday of last week, the yield on this bond fell from 4.69 percent to 4.59 percent because the Fed reduced inflationary expectations by tightening monetary policy. In short, whatever impact deficits have on long-terms rates is overwhelmed by other factors that may operate in the opposite direction.
In the long run, the best way to keep mortgage rates low is by keeping inflation low. Deficits matter in this regard very little and Federal Reserve policy matters a lot. The Fed has taken the first important step toward strengthening the dollar by tightening monetary policy. It’s a step somewhat overdue, in my opinion, but still a move in the right direction.