Tuesday, December 23, 2014

The first half of 2015 will be a tipping point

This is an interesting period of time, coming out of QE3.  Inflation expectations and real interest rates rose during the QEs, and then declined coming out of the QEs, and in hindsight, QE3 seems to have created the same basic pattern.  Short term treasury rates are distorted by the curvature at the short end of the yield curve.  This first chart is the 5 year, 5 year forward real interest rate (approx.) and expected inflation.  This shows the tendency for both real rates and inflation expectations to have risen during QEs and fallen afterward.  Long term real rates are lower now than after QE1 or QE2, even though it still appears as though a rate increase might happen.

All of the QEs stabilized the forward yield curve, bringing us closer to the point where short term rates might rise above the zero lower bound.  The length of QE3 was helpful in this regard, since we are now back to within six months of the expected date of interest rate increases for the first time since the beginning of the crisis.  (I think this is the case, but my data prior to QE3 isn't as precise, so I'm not certain.)  With the pullback in October, it looked like the expected date of the first rate increase might start moving forward in time again.  But, this has recovered, and as of Friday, the expected first rate increase was less than 6 months away for the first time in a long time.

QE3 seems to have improved near term expectations enough to firm expectations for the eventual rate increase, but at the same time, long term forward rates have declined.  Here we can see the yield curve for Eurodollar futures over time during QE3.  The time frame for rate hikes has remained fairly stable.  By the end of 2013, the timing of the first hike had moved back somewhat, but most of the effect was to increase the slope of the yield curve after hikes began, and to increase the expected final level of rates after rate hikes would have ceased. The expected rate hike remains in mid-2015 now, but the slope of the yield curve is fairly flat again, and most strikingly, the long end of the curve has moved even lower than it had been at the start of QE3.  This suggests that Fed Funds rates are expected to top out at around 2.5%.  (Some of the Eurodollar rates after about 2017 would reflect the TED spread and a maturity premium over the expected future Fed Funds rate.)

Markets seem to expect that we will have a very hawkish Fed, but that we will escape the zero lower bound in spite of it.

We now have two countervailing forces working on inflation and interest rates.  Commodities prices are in steep decline.  The broad decline in dollar terms suggests a monetary source for this, although there may be some supply influences, also.  So, this should be related to a decline in inflation along with some increase in real consumption.  In the meantime, real estate prices are leveling out, which looks like it is mostly the result of less supply, due to credit market constraints (stagnant bank lending, which may soon improve) and the premature exit from QE3 (household leverage still too high).  (edit: This is decreasing the supply of new homes, which is causing rent inflation.) This is increasing inflation at the expense of real incomes.  But, since most households are also home owners, the negative effect of the housing supply problem on incomes may be muted.  Beyond its effect on nominal incomes, I am not sure of the effect of the housing constraint on interest rates, since expanding mortgage markets will effect both investment supply and demand.

The next six months should lead to some important discoveries about the future path of the US economy.  The Wizard of Oz theory of the Fed is not helpful here.  Rates won't rise in mid-2015 just because the Fed decides that they will.  If the Fed decides to hike rates inappropriately, the yield curve will flatten, and we will be in for a nasty ride.  There will be no mistaking it.  If forward rates remain elevated when the Fed starts to increase Interest on Reserves and the Fed Funds Rate, we will know that the US economy had enough momentum to expand while at the zero lower bound.  Then the question will be whether the Fed manages the subsequent money supply in a way that keeps us off of the ZLB.  I am not hopeful about that, since it probably necessitates an inflation target above 2%.  But, it's a much better problem than the problem of never leaving the ZLB to begin with.


  1. I wish somebody would ponder a world with long-term QE...Martin Wolf has...it may be what is needed

    1. As Sumner points out, it's a sort of capitalist koan. If you commit to long-term QE, you don't need long-term QE. Do you agree with Sumner on that point?