What Is the Ten-Year Real Rate Going to Be? II: Peering at the Future Fundamentals of the Flow-of-Funds Supply-Demand Balance
What are the odds that bond rates are going to return to the 2010s normal? Low, although at least some mean-reversion seems highly likely, plus in the future rates are likely to be lower on average than today’s late-cycle rates. But what are the chances interest rates are only partly through a régime shi ft that the market is only recognizing slowly? There are four perhaps-sensible possible drivers of such a régime shift: (a) reversal of the Cold War-end peace dividend, (b) investment requirements for green technology, (c ) the coming of a new investment heavy GT-LLM-ML-driven leading sector, or (d) that the equilibrium rate is really a social and not an economic fact…
The 10-Year U.S. Treasury Bond’s real interest rate is now above 2% per year: time to worry about the deficit again?
Does that mean it is time to worry about the deficit again? On the one hand, perhaps not. With 1% per year future U.S. population growth, with a reasonable hope with policies aimed at actually boosting investment of 1.5% per year productivity growth, it is still the case that g > r unless you believe that we are still at mid-cycle—that interest-rate increases still have a way to go, so that on average over future business cycles interest rates will be as high as they are today, or perhaps higher. And that is not where current judgment is, at least within the halls of the Eccles and the Martin buildings:
Tim Duy: Federal Reserve Governor Chris Waller cleverly raised the bar for another rate hike at the December FOMC meeting: ‘“I find myself thinking about two possible scenarios for the economy in the coming months. In the first, the real side of the economy slows. This is the scenario broadly reflected in the September Summary of Economic Projections (SEP) by FOMC participants, where an easing in demand helps bring the economy into better balance with supply and allows inflation to move closer to our 2 percent objective. In this scenario, I believe we can hold the policy rate steady and let the economy evolve in the desired manner…” This says that if the economic data supports an outcome broadly in line with the September SEP, Waller doesn’t see a need to hike rates even though that same SEP projected another rate hike…. To be sure, the Fed wasn’t going to say directly it wouldn’t hike in December, but by raising the bar to a rate hike, Waller makes the September SEP no longer valid. It’s not the guide for another hike…. [And] Waller arguably raises the bar… even further…. Low inflation or low growth alone is enough to forestall further hikes…
Thus the current central case is that, while we can no longer realistically hope that we will grow out of deficits without taking any action, reducing the rate of growth of the nominal national debt is only worth doing to the extent that we think we need insurance. Insurance against what? Either against another large macroeconomic shock further steepening the slope of the intertemporal price system, or in order to provide extra fiscal space to meet some future emergency requiring additional mammoth government spending in which it is, somehow, not appropriate to pay for that additional tranche of spending via higher taxes at the time.
On the other hand, there is the possibility that we are still only part of the way through an economic régime shift, which is now-ongoing but only half-recognized, that is pushing up the long-run average future value of the 10-Year US Treasury rate—and that will push it up still further. It is too soon to focus on that possibility. But it is not too soon to say perhaps…
What factors might be driving such a shift?
Last time I argued that there are four factors that determine the future value of the 10-Year US Treasury rate: [1] the true equilibrium rate, [2] expected inflation, [3] the safety interest rate discount, and [4] the stance of the Federal Reserve. I argued that the ebbing of temporary factors associated with [2], [3], and [4] were likely to put 0.5%-points of downward pressure on the 10-Year Treasury, which is currently at 4.7%. However, that leaves the rise from 2.5% in the 2010s to 4.2% remaining. That leaves only [1].
And I ended last time with a question: Is that large 2.1%-point increase consistent with changing fundamental factors that have increased the true fundamental “neutral” equilibrium rate, the one that balances savings and investment in a full-employment economy?
By coincidence, I again see four factors—I see four perhaps-sensible arguments for believing that the bulk of the interest-rate rise is a result of changing fundamentals: