By Randy Myers
The financial markets appear to be getting it right.
As the Federal Reserve continues to pursue an extraordinarily expansive monetary policy, it is hard to know where interest rates are, where they should be, or how quickly and dramatically they might change once the Fed finally begins to shift to a more normal monetary stance. Michael Simpson, head of strategic portfolio management for Transamerica, asserts that interest rates—both in the spot and futures markets—are behaving the way politics, theory, and history suggest they should. “Barring an economic shock,” he told participants at the 2013 SVIA Spring Seminar, “the markets have it right.”
One key to understanding where rates are heading, Simpson said, is to pay attention to what the Fed is saying. The Fed has said it intends to keep the target for the federal funds rate—the overnight rate at which banks borrow from one another—near zero percent as long as the unemployment rate stays above 6.5 percent and the outlook for inflation stays below 2.5 percent. Trading in futures contracts for both Fed funds and Treasury bonds, Simpson said, indicates that investors are anticipating the Fed will begin to tighten monetary policy in the fourth quarter of 2015. That dovetails with the Fed’s forecast that the unemployment rate will be between 6 percent and 6.5 percent by that time. “It is commonly understood that the Fed’s growth forecasts have been high,” he said, “so it is reasonable to agree with the markets and go with the top end of the Fed’s range.”
Simpson noted that the Fed has been making an effort to communicate how long it plans to keep short-term interest rates near zero percent so that investors can price that into their thinking. “This has resulted in forward rates that reflect the best estimates of future Fed policy actions,” he said.
The Fed also has outlined the exit strategy it will likely use when it begins to tighten monetary policy. Because it has laid out so clearly what it is doing and what it intends to do, Simpson said, the Fed’s move toward a tighter monetary stance should not be too disruptive. “Interest rates probably won’t jump dramatically just because the Fed says it’s going to stop buying Treasuries and mortgage-backed securities and start selling them instead,” he said. “Rates could jump drastically if the Fed said it was going to sell everything on its books at once, but it probably won’t do that.”
In fact, Simpson said, several factors could pressure the Fed not to raise rates too quickly. With about $11.5 trillion in federal debt outstanding, he noted, even a 100-basis-point increase in interest rates would add $150 billion to the federal government’s debt service costs. So raising rates is nothing to do cavalierly. Private borrowers, too, would be squeezed. “There may well be some feedback,” Simpson concluded, “that constrains the rates at which interest rates can rise.”
Just as interest-rates have been consistent with what the Fed has been doing and telegraphing, so too has the performance of the overall economy aligned with what history tells us. As would be expected, credit and nominal GDP, which surged prior to the 2008 financial crisis, have since fallen by a comparable amount. Real GDP growth is substantially lower, the unemployment rate is significantly higher, real housing prices are down, and the real value of government debt has surged.
Against this backdrop, a number of additional factors are holding back the economy. The defining feature of the financial crisis was the massive amount of debt, or leverage, that had piled up in both the public and private sectors, Simpson said. Leverage accelerates economic growth. But now both the public and private sectors are deleveraging, which inhibits growth. The economy is being restrained by the sequestration cuts in federal spending that began to take effect this year, by slowing productivity growth as well as a weakened European economy. All this suggests, he said, that we can expect the recovery from the 2008 crisis to continue to proceed at a slow pace, keeping downward pressure on interest rates and inflation for the next few years. While real GDP growth should be 2.4 percent, he said, it is more likely to be in the 1.5 percent to 2 percent range.