7 minute read
As an investor, it’s vital to monitor Federal Reserve policy.
Why?
Because the Fed influences the liquidity cycle (aka the expansion or tightening of credit).
In fact, there’s an old saying on Wall Street.
“Don’t fight the Fed.”
This means that one shouldn't bet against the current direction of monetary policy.
For instance, if the Fed’s tightening, then it’s seemingly unwise to rush into riskier assets. And vice versa when the Fed’s easing.
But sometimes the bond market does fight the Fed…
That’s what an inverted yield curve1 indicates – i.e. when the Fed hikes short-term rates up enough (expecting growth and inflation) but the long-end begins pricing in a slowdown and deflation instead. Hence the yield curve flips upside down.
And while this is simple to understand (relatively), there’s one question many never seem to ask.
Or, when they do ask, the experts don’t seem to know how to answer.
“When the Fed adjusts interest rates, what are they cutting or hiking against?”
See, for instance, when the Fed raises interest rates to try and tighten credit and slow growth, it must push short-term rates higher relative to other interest rates across the curve.
Thus, in theory, as the short end of the yield curve rises - so should the long end in lockstep.
But – at times – the yield curve inverts instead, which skews bank and financial plumbing.
In fact, historically when the Fed does eventually tighten, it overdoes it and often leads to a recession or some kind of crisis.
To give you some context, an inverted yield curve has preceded every2 US recession in the past half-century.
So, what gives?
Well, lucky for us, there’s a compelling reason for this. And that’s the ‘natural rate of interest’ theory.
This is something even the Federal Reserve uses3 to set monetary policy.
How else do policy members estimate if they’re overtightening or overstimulating? Remember, interest rates are relative to one another.
So, let’s take a closer look at this relatively unknown – but key – concept…
What We Can Learn From A 19th-Century Swedish Economist
Knut Wicksell was a Swedish-born economist who lived from 1851 to 1926 and made significant contributions to the realm of monetary economics and interest rates. Among his many valuable writings, his most renowned work is "Interest and Prices (1898)”.
Wicksell is credited with pioneering the concept of the 'natural rate of interest.'
In Wickell’s theory, the natural rate of interest signifies that in an economy where central banks do not intervene in interest rates, interest would still exist and would likely align with the return on capital, inflation expectations, and economic growth.
Put simply, it’s the interest rate that economic fundamentals justify.
The natural rate of interest is the genuine rate that neither stimulates nor constrains an economy.
So, when growth, returns on capital, and inflation are low, interest rates tend to be low as well. And conversely when these factors are high.
Thus, according to Wicksell, as long as the market interest rate (essentially what the central bank sets at the shorter end) aligns with the natural rate (what the economic fundamentals justify), the desired saving will be equivalent to the desired investment, leading to an equilibrium between aggregate demand and aggregate supply, resulting in price stability.
However, any disparity between these two interest rates will trigger price changes and economic fundamentals.
And this divergence between the natural rate of interest and the nominal market interest rate, known as the ‘Wicksellian Differential’, plays a crucial role in driving the business cycle.
For instance, when a central bank maintains an easy monetary policy by establishing the nominal interest rate below the natural rate, it can pave the way for an unsustainable economic upswing marked by excessive credit creation, inflationary pressures, and the emergence of speculative asset bubbles.
Conversely, if the central bank sets the nominal interest rate above the natural rate, it can create a restrictive economic environment, potentially triggering a slowdown or recession.
Thus, the concept of the Wicksellian Differential serves as a gauge of the variance between the central bank's monetary policy stance and the underlying economic circumstances. Most notably because a central bank essentially controls the short-term yield curve.
I hope I haven’t lost you yet. Because it’s about to get interesting. . .
So, What Do Natural Rates of Interest Tell Us About Global Yields and Monetary Policy?
Now, you may be wondering, “How can we calculate the natural rate of interest to know if market rates are stimulating or constricting?”
Well, that’s the tricky part. Because it technically can’t be directly observed as a market interest rate (aka the rates that institutions or consumers lend and borrow at).
However, there are models that use a variety of economic fundamentals to try and estimate the natural rate. From demographics and productivity to fiscal policy and investment returns.
Most show that natural rates have steadily declined globally since the 1980s on the back of too much debt, too little growth, relative deflation, diminishing returns, and poor demographic trends.
To put this into perspective – according to an International Monetary Fund (IMF) paper4 from April 2023 – ‘real’ (adjusted for inflation) interest rates have trended lower for decades across advanced economies. And even remained chronically negative after 2008 as the natural rate kept declining.
The only thing to meaningfully push up real interest rates over the last 18 months is the aggressive central bank tightening and higher inflation expectations.
But this may be short-lived. . .
In the same paper, the IMF notes, “The analysis suggests that once the current inflationary episode has passed [post-pandemic], interest rates are likely to revert toward pre-pandemic levels in advanced economies.”
A big reason for this decline in global natural interest rates – as shown by the IMF analysis - is aging demographics and eroding total factor productivity (TFP; the total output relative to inputs and is often considered the primary contributor to GDP growth).
This indicates that central banks and fiscal authorities have had to aggressively push short-term rates below market rates to keep growth going.
For instance, fiscal policy was an important offset, particularly in Japan and Brazil, as the economies required stimulus to offset declining productivity and weaker demographics.
Now, keep in mind that according to Wicksell’s concept, this chronic decline in the natural rates of interest has serious implications for global central banks.
For starters, most of these declines are structural issues that will weigh it lower and lower (such as the aging population, declining productivity, and excess debt).
Meanwhile, central bank policies are cyclical.
As mentioned above, if the natural rate is declining, then central banks must push short-term rates below it to spur growth.
So, let’s say the natural rate is 1%. That means the central bank must keep rates at 0% or even go negative (as we saw in Japan and the Euro area) to stimulate.
This is why central banks went much further with their ‘unconventional’ policies post-2008 – deploying quantitative easing (QE), negative interest rates (NIRP), and yield curve control (YCC) - to try and get things going.
But this also has serious complications when central banks want to raise interest rates in “normal” times.
Why? Because if the natural rate is chronically low, there’s a much higher chance a central bank overtightens and restricts growth, pushing them back lower than before.
This implies that the use of ever-more aggressive central bank policies will continue in the future as central bankers try and deal with structural issues weighing down natural rates.
This is something to keep an eye on because it will influence monetary policy around the world over the next decade
Summary
Global natural interest rates have been falling – on the back of structural issues – for decades and have thus pushed central banks into ever more easing.
This decline poses challenges for central bankers, as it limits their ability to spur growth through traditional means (for instance, look at Japan or Europe).
Additionally, the chronic decline in natural rates complicates the process of raising interest rates during "normal" times, as it increases the risk of overtightening, thus restricting growth, popping asset bubbles, and increasing financial instability.
So, to gain insights, we turned to the pioneering work of Knut Wicksell and his work on the natural rate of interest.
His theory suggests the interplay between central bank actions, natural interest rates, and fiscal measures that will continue to shape the financial landscape in the years to come.
But, in the face of such deep structural issues pushing natural interest rates lower, central banks may increasingly resort to even greater unconventional policies.
And as economies lean on fiscal stimulus to counteract these challenges, both the future of the bond market and monetary policy remain uncertain.
But, I believe yields long-term may continue declining globally as growth, demographic, and investment momentum fades and the monetary authorities eventually begin easing sooner rather than later to deal with these.
Just some food for thought. . .
Sources
- https://dunham.com/FA/Blog/Posts/navigating-an-inverse-yield-environment
- https://ig.ft.com/the-yield-curve-explained/
- https://www.newyorkfed.org/newsevents/speeches/2023/wil230519
- https://www.imf.org/en/Publications/WEO/Issues/2023/04/11/world-economic-outlook-april-2023
Disclosure:
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