With interest rates now positive in real terms, the impact of policy tightening on the economy should become more evident.
The Federal Reserve’s decision to leave interest rates unchanged at this week’s Federal Open Market Committee meeting was widely anticipated as Chair Jerome Powell and other officials previously signaled the outcome. Following the announcement, both stocks and bonds rallied amid hopes the Fed's tightening cycle is done.
Heretofore, the Fed’s stance has been that it will weigh an array of economic data in making a determination on interest rates including trends in inflation and jobs. However, the Fed’s willingness to leave rates unchanged in the wake of a series of strong jobs reports and nearly 5 percent annualized growth in real GDP in the third quarter indicates other factors are being weighed, as well.
One is the spike in Treasury bond yields of a full percentage point since the Fed last raised rates at the end of July. In a speech before the Economic Club of New York, Powell acknowledged that the spike in yields was tightening financial conditions and could lessen the need for additional Fed rate hikes “at the margin.”
Another consideration is increased geopolitical risks in the wake of the unprovoked attack on Israel by Hamas. Markets have not reacted to the provocation thus far, mainly because members of OPEC are not threatening to curb oil production as they did 50 years ago during the Yom Kippur War. The risk, however, is that the conflict could escalate throughout the Middle East depending on how Israel retaliates to the attack. If so, oil prices could surge.
In the process, the Federal Reserve has gone from being data-dependent to also being market-dependent.
Some observers believe it is a mistake for the Fed to let markets do its job in setting interest rates. James Mackintosh of the Wall Street Journal contends that the Fed is putting too much faith in the markets. He questions why bond yields have spiked when inflation has come down and short-term rates are unchanged.
The most common explanation is that the surge in bond yields reflects an increase in the term premium — the additional yield on bonds that captures all the uncertainties that investors accept in holding long-dated bonds. One possibility is investors are concerned about outsized federal budget deficits increasing the supply of government bonds while the Fed is allowing bonds to roll off its portfolio as they mature. However, Mackintosh finds it odd that investors have only worried about this recently.
My own take is that it would be improper for the Fed to base its decision on interest rates solely on bond yields. Indeed, until recently bond investors were expecting the Fed to cut interest rates this year and for yields to decline even though the Fed consistently signaled that it intended to keep rates higher for longer.
That said, it would also be a mistake for the Fed to ignore the spike in yields. The primary reason is they can directly impact the economy and lessen the chances for a “soft landing.” Economists at Deutsche Bank and Goldman Sachs estimate that the tightening of financial conditions could lower economic activity next year by 0.6-1.0 percentage points, respectively. In the Q&A after the FOMC meeting, however, Powell cautioned that the impact hinges on how persistent the tightening of monetary conditions is.
The U.S. housing sector looks particularly vulnerable now. Although residential investment turned positive in the third quarter after declining since the Fed began its policy tightening, the uptick is likely temporary. Recent indicators show homebuilder sentiment has plummeted and housing sales are the weakest since 2010.
U.S. home prices have not cracked thus far mainly because inventories are low, and 90 percent of homes are financed with 30-year fixed-rate mortgages according to Freddie Mac. However, with long-term mortgage rates now at 8 percent, housing affordability is the most expensive on record due to the combination of house price appreciation and rising mortgage rates. Consequently, the fate of the housing sector is now more closely tied to the bond market than to monetary policy.
More evidence that interest rates are beginning to take a toll on the economy is apparent from data from Equifax on consumer credit: This year, credit card delinquencies have hit 3.8 percent while defaults on auto loans have increased to 3.6 percent, which are the highest levels in more than 10 years.
The housing and auto sectors are important because they traditionally are the first to weaken in response to higher interest rates. While they have held up thus far, they could still succumb considering that monetary policy works with lags.
Weighing all these uncertainties, the prudent course for the Fed is to signal its willingness to keep rates on hold for an extended period. This could help to stabilize the bond market by lessening uncertainty about what it is likely to do at each FOMC meeting. With interest rates now positive in real terms, the impact of policy tightening on the economy should become more evident.
Finally, the Fed’s commitment to lower inflation is more credible today than when it began tightening policy and had to play catch up.
Nicholas Sargen, Ph.D. is an economic consultant with Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books including "Global Shocks: An Investment Guide for Turbulent Markets."
