10-year Treasury yields inched up again Thursday, closing above 1.7% for the first time since early 2020.[i] With this move, Treasury yields erased their pandemic plunge, which one might rationally call another indication of the economy’s returning to normal. But reason seems to be in short supply, as we have basically seen two schools of thought among pundits. The first argues rising long rates mean big inflation looms, dooming us all if the Fed doesn’t tighten monetary policy. The second, seeing higher inflation as a desirable sign of burgeoning demand, doesn’t acknowledge the strong correlation between long-term interest rates and inflation. Instead, they worry rising long rates amount to premature tightening, dooming us all if the Fed doesn’t intervene with more bond buying under quantitative easing (QE) to tamp rates back down. In our view, both camps are making the same central error: presuming low long-term rates are indeed loose monetary policy.
The reason that thesis is off base, in our view, is the same reason long rates correlate with inflation: Long rates’ role in monetary policy stems from the yield curve. Steeper yield curves have a long, long history of getting money moving. They motivate banks to lend, which pumps more money through the economy, driving faster growth and, as a byproduct, inflation. For the yield curve to be steep, long-term rates must be well higher than short. If long rates are only mildly above short rates, the flatter curve doesn’t do enough to encourage banks to take the risk of lending. Banks borrow at short rates and lend at long rates, with the spread their profit on new loans. Smaller profits mean less reward for taking risk, which discourages lending. That means slower money supply growth. Less money flowing through the economy drags down growth and inflation. (An inverted yield curve, with short rates above long, is generally contractionary and deflationary, but that is a topic for another day.)
With this in mind, let us examine the amusing irony of both schools of Fed watchers. The first school wants the Fed to slow QE down or end it, encouraging higher long-term interest rates. They miss that this would, all else equal, steepen the yield curve and lead to the faster inflation they want to prevent. That outcome would fulfill the goal of the second school. But they would rather have the Fed buy more long-term bonds—which would flatten the yield curve, slow growth and inflation and, in the end, make the first school happy. And that, folks, is the weird place most analysts have reached: Each side’s chosen monetary policy prescription would only worsen their perceived problem.
The simple way to see through this conundrum is to remember the immortal words of Milton Friedman: Identifying tight money with high interest rates and easy money with low interest rates is a fallacy. Interest rates were high and rising throughout the 1970s, when money was easy and inflation galloped ahead. They fell in the 1980s, leading to a liquidity crunch and 1987’s bear market (which included Black Monday). Japan has had rock-bottom rates for nearly a decade now. Inflation? Lending? They are barely crawling.
To assess monetary policy, we suggest chucking surface-level views. Don’t simply look at interest rates and presume high or low has a preset outcome. Rather, look at the whole yield curve. Look at the spreads. Are they sufficiently wide to encourage lending or flat like today’s? Look at money velocity, the rate at which money changes hands in the economy. It has tanked in the post-2008 era, coinciding with the Fed’s yield-curve-flattening rate policies, like zero percent short rates and QE. Considering these factors, monetary policy is much tighter than either of these camps presume based merely on long-term rates.
Now, none of this is to say we think these camps make no sense. There is an argument to be made that inflation is a risk now, based on the increase to the monetary base the Fed stoked in restarting QE last year. But, as we have written, it is more a risk if long rates rise than if they fall, based on Fed intervention or other factor. Rising long rates would likely encourage more lending and stoke inflation beyond what policymakers envision today—forcing them to play catch up. As they do, they may overshoot and hit stocks and growth in the process.
But those things aren’t at hand today. Instead we still have the confusing conundrum of pundits who think the Fed should talk rates lower to get inflation higher, despite oodles of evidence the two are linked—and others convinced low long rates risk fast inflation, despite everything the last decade globally (and 30 years in Japan) has shown them.
[i] Source: FactSet, as of 3/18/2021.
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