Monetary Policy

For Bond Yields It’s Mostly the Reopening Economy (Not Inflation) for Now

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While there are certainly inflationary risks on the horizon, it would be a mistake for the Fed to act prematurely.

Considered an indicator of investor confidence, the ten-year Treasury bond yield has risen rapidly by about 0.7 percent since the beginning of the year. Many experts credit the rise to expectations for substantially higher inflation. Yet this view is overly simplistic and hasty. The recent increase in returns on ten-year Treasuries has more to do with the improving U.S. economic outlook and with real interest rates rising than it does with inflation. There are certainly inflationary risks on the horizon, but it would be a mistake for the Fed to act prematurely.

The risk of the Fed signaling or tightening policy too soon are substantial. As Milton Friedman and Anna Schwartz famously pointed out in A Monetary History of the United States, the Fed exacerbated the Great Depression by contracting the money supply. In 2019, we argued at the Wall Street Journal that the Fed made a mistake in raising interest rates too much in 2018 — and the central bank cut rates shortly after our article was published in 2019. We similarly worry that inflation hawks may be prompting the Fed to repeat that mistake.

Movements in interest rates reflect a number of factors, but the two more prominent are expectations about the future path of economic growth and the future path of inflation. If economic expectations are driving an increase in rates, we should be celebrating rather than worrying about inflation. Sure, rising interest rates will cause some short-term pain in the stock market (much like they did following the Great Recession), but the stock markets will recover after pricing in new discount rates.

Amid the mass distribution of vaccines, COVID-19 cases and hospitalizations have been declining dramatically, while jobless claims have dropped to their lowest level since the pandemic reached the United States. Investors’ expectations for a labor-market recovery and substantial economic growth are thus naturally improving. The Atlanta Fed’s GDPNow model’s forecast of first-quarter GDP growth recently jumped above 8 percent as the level of U.S. GDP is still catching up to pre-COVID levels. That’s all good news.

Inflation has begun increasing but, to this point, only nominally so. It is important to keep in mind that the Fed recently shifted its monetary framework to “flexible average inflation targeting” over the long run. Since we’ve seen drops in inflation over the past year, we think that the Fed’s current accommodative policies are the right framework to make sure inflation runs at an average of 2 percent over the long run.

Recently, we have seen little increase in core inflation rates, which exclude gas and food prices. U.S. core CPI year-over-year inflation has been running at 1.3 percent through February compared with the 1.7 percent headline number, which includes oil prices. Rapidly rising oil prices (Brent crude-oil prices rose from about $50 per barrel at the beginning of the year to $70 per barrel as of this writing) are largely responsible for the nominal increase in headline inflation.

Core year-over-year PCE inflation (the Fed’s preferred measure) has been running at 1.5 percent through January, still well below the Fed’s 2 percent long-run target.

Expectations for future inflation also remain low. Real yields on ten-year Treasury Inflation-Protection Securities (Treasury bonds indexed to inflation to protect investors from the negative effects of rising prices) have risen by 0.4 percent since the beginning of the year, reflecting improved U.S. investment prospects while also suggesting that headline ten-year inflation expectations have increased by only 0.3 percent.

The M2 money stock (a measure for the amount of currency in circulation) has increased by a meaningful 20 percent since the passage of the CARES Act, understandably raising inflation concerns. But, it has leveled off since, suggesting a one-time increase. A one-time increase shows up more meaningfully in five-year inflation expectations (which are up 0.6 percent since January 1) compared with ten-year inflation expectations (which have risen only 0.3 percent).

This is not to downplay the potential for inflationary pressures down the road. With the passage of the Democrats’ recent $1.9 trillion so-called COVID-relief American Rescue Plan Act, there is certainly a risk that the economy could overheat. The fact is that the economy would have substantially improved this year — and may well have done so without dramatic inflationary pressure — if the Biden administration had done nothing. Unfortunately, it likely did too much in its effort to “go big.”

Just over the past few months, Congress has passed stimulus measures equivalent to 15 percent of GDP while savings rates, wages, and pent-up consumer demand are all high. This creates the possibility of demand grossly exceeding supply and causing meaningful inflationary pressure, especially if the incumbent Democratic Congress passes further spending and stimulus measures.

But we are not there as yet. While we are seeing some small current gains in inflation, as Fed chair Jay Powell said in a recent press conference, “there’s a difference between a one-time surge in prices and ongoing inflation.” He is right. We have got a way to go before average long-run inflation hits the Fed’s 2 percent target. At this point, there is no need for the Fed to change to its current policy stance.

Jon Hartley is a master’s student at the Harvard Kennedy School and a visiting fellow at the Foundation for Research on Equal Opportunity. He formerly served as a senior policy adviser to the Congressional Joint Economic Committee. Andy Puzder is the former CEO of CKE Restaurants and a senior fellow at the Pepperdine University School of Public Policy.

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