Fed Policy, Interest Rates, and the Yield Curve: Why the Fed Won't Tighten (much)

The Fed has been talking about interest rate hikes, yet the market doesn't buy much of the tough talk. Here is why, and here is why it complicates the Fed's strategy quite a bit. A MUST read, especially for those in stocks, bonds, and currencies!

Central banks change interest rates with the objective of controlling money growth so that inflation remains close to target (generally 2%) and the entire economy runs close to its "potential." Like the pilot of a car, to "hit the breaks" and slow down the economy, it raises rates, and to accelerate short run activity and inflation, it decreases rates. The last Fed rate hike campaigns were early 1990s, end of 1990s, and 2004-2007.

​Bubble issues
Generally, you tighten policy when there is a clear threat of inflation busting into the upper limit of tolerance (2%-3%) and when inflation expectations are on the rise. There is NO sign of this happening now or in the near future. The problem is that if you keep rates too low for too long, you could end up with a problem of asset price "inflation": stocks, bonds, housing, credit, gold, etc. All these assets may inflate due to the massive amounts of liquidity in search for returns. When inflation does "finally appear" on the horizon and you have to increase rates, it can cause a bursting of bubbles and a disruption in financial markets, which could end badly, as seen in 2008. This is one of the reasons some FOMC members want to at least start increasing rates now.

The problem of inflation expectations
In a nutshell and to somewhat oversimplify, nominal market returns follow inflation expectations (and risk+liquidity premia). So "interest rates" in general follow the broad movements of inflation expectations. Inflation expectations dropped in 2013 and remain low in the USA (and the world), putting a "break" on the potential for rate hikes: increase rates and you kill already-low inflation, which could drive expectations even lower and drive up real rates, which are inversely related to inflation expectations.

​The ultimate challenge: the Yield Curve!
The difference between short term rates and long term rates is very important. Why? Because banks "borrow" short term and "lend" long term, as is the case of many financial institutions. For example a bank finds 1 million dollars by convincing many clients to freeze their money in a 2 year "certificate of deposit" with close-to-zero return and lending that 1 million to a company or a household (for a mortgage) for 10 years at a 3% rate. The difference between the cost of funds and the returns on the use of funds gives the bank a profit.

When the difference between the 2 rates becomes small, it becomes harder for financial institutions to do business, and this can create a lot of problems in markets and the economy if it degenerates, as seen in Japan and Italy in recent years. This "difference" between long term 10-year bonds and short term 2-year bonds is important. Here is how that difference has been trending for the USA:
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In a nutshell, it has been trending down for 2 years...

So what would happen if the Fed raised rates (which are the SHORT term rates) and that the long term rates did not respond one-for-one? The difference between the 10-year return and the 2-year return would DECREASE, and that could become problematic for the Fed, because it would add financial stress to the market. 

Talking up the long rates
Fed officials are desperately trying to pump up the long term rates to have more room to increase short term rates without causing too much financial stress in markets with a flattening yield curve. How are they doing this? They are signalling to the market that rates will increase in the future and they hope that this will drive up the long term rates through what is called the "term structure of interest rates"... don't worry if you don't know about this, it's not that important for this post. What matters is that as long as the difference between short and long term rates is "small" ("flat yield curve"), there is little space for the Fed to hike rates. The market knows this and does not buy the tough talk from the Fed.

The strategic dead end
If the Fed raises rates in the middle of a sluggish growth context, low inflation, and low employment rate, the long term side of the yield curve may not respond, and the yield curve will flatten, thus adding stress to financial markets and decreasing the options for further rate hikes caused by the flattening yield curve.

If the Fed does NOT raise rates, it is sending the signal that it does not believe in strong growth going forward, adding to the stress about the outlook for 2017 and perhaps precipitating a stock market crash and feeding negative expectations, which flatten the yield curve. Not raising rates also discredits the already-shaky credibility of the Fed`s "forward-guidance" communication strategy and can also feed asset bubbles down the road.

Damned if you do, damned if you don't. The market will believe when it sees it. Classic first-mover strategic problem! The "exit strategy" from QE seems to be hard to pin down.

Fine-tuning the yield curve
The Fed may start targeting the yield curve as an extra policy tool, on top of QE and standard overnight interest rate changes. Japan is doing this: trying to keep a positive sloping yield curve to avoid financial market stress. Do do this, the central bank buys and sells different bond maturities to influence the price (hence the yield) at various maturities.

The other problem for the Fed is that it is the ONLY central bank with a tightening bias. All others are in neutral or loosening bias: ECB, BOJ, BOC, BOE, RBA, RBNZ, etc. It can't "go alone" towards tightening, especially in the absence of inflation, falling inflation expectations, and sluggish global growth.

So the Fed is talking tough to pump up the 10-year yield to open up the door for rate hikes without creating financial stress with a flattening yield curve, but as long as the yield curve will remain quite flat, any significant tightening is not credible. They may increase rates ONCE in December, to avoid sending a panic signal and in the hope of pumping up long term yields, but unless the yield curve goes at least a bit more vertical and inflation increases, any extra hikes will be low-probability, regardless of tough talk. A tough balance to strike indeed!

For your convenience, here are the current 2-year and 10-year bond yields for selected economies, and 10-year minus 2-year yield spread:

The ones with a flat curve but have a cutting bias do not have a problem, as cutting will typically steepen the slope and decrease financial stress. The Fed is the only one with a tightening bias, which risks flattening the yield curve...

Conclusion
The Fed is in a very tough spot, with a relatively flat yield curve that it could flatten more if it increases rates, no inflation, and sluggish growth. It needs a steeper yield curve to have room for rate hikes that would contain bubbles and avoid a faster rate hike campaign down the road, which could prove disruptive. Yellen's talk of "overheating" and other Fed official speeches may be trying to pump up long rates to steepen the yield curve. No inflation, low inflation expectations, a sluggish global economy, and a relatively flat yield curve all suggest there is very little room for rate hikes. Keep this in mind once the December speculation is over. Please like and share if you liked!