Interest-Rate Pain From Higher Inflation Has Barely Begun

In the decade before and then through the early pandemic, the Fed was fighting to keep the economy growing and inflation from slipping below 2%. So it kept real short-term interest rates negative and bought bonds, which helped keep real bond yields below 1%. Low real rates bolstered stock and housing prices, and encouraged businesses to borrow; corporate debt climbed to a record relative to gross domestic product. (Households’ leverage plummeted after the financial crisis and hasn’t really recovered since.)The Bank for International Settlements recently evaluated what would happen if advanced economy central banks raised their policy rates 4.25 percentage points, as much as the Fed tightened in 2004-2006. Housing and equity prices would both end up 5% lower, adjusted for inflation, in 2025 than now, and private-sector debt service would consume an additional 3% of income. Federal budget math also gets ugly. In 2007 publicly held debt was 35% of GDP. A financial crisis, pandemic and two recessions later, it is 98%. But because bond yields have fallen from 5% then to 3% now, the cost of servicing that debt hasn’t increased.Furthermore, the Fed bought a lot of those bonds to hold down yields, remitting their interest back to Treasury. It paid for the bonds by issuing newly created electronic money, called reserves, to commercial banks, with an interest rate of close to zero. The Congressional Budget Office reckons a one-percentage-point increase in real rates will boost the annual deficit by $250 billion in 2026, or roughly 1% of GDP. Debt, already on an upward trajectory, will rise even faster.

Greg Ip, "Interest-Rate Pain From Higher Inflation Has Barely Begun,"Wall Street Journal, July 20, 2022, https://www.wsj.com/articles/interest-rate-pain-from-higher-inflation-has-barely-begun-11658327626

Interest-Rate Pain From Higher Inflation Has Barely Begun

Inflation hurts for many reasons, but one of the most important is that it usually means higher interest rates. Yet in the past year, while inflation has jumped 7 percentage points, the Fed’s short-term interest-rate target has gone up just 1.5 points and the 10-year Treasury note yield just 1.9 points.

The gap reflects a belief by investors that in a few years, inflation will relatively painlessly slide back to around 2%, the Federal Reserve’s target, allowing rates to return to the ultralow levels that prevailed before the Covid-19 pandemic. What if instead inflation remains stubborn and rates have to rise a lot more? That would spell trouble for an economy where asset values, private and public debt have risen on the assumption that rates will remain historically low.

Higher inflation boosts profits, incomes and asset values and thus neutralizes the effect of rising nominal rates. Thus, monetary policy becomes restrictive not through higher nominal rates, but higher real rates—nominal rates minus inflation.

Low real rates also became a justification for governments to worry less about deficits and debt, which President Biden’s team incorporated in their stimulus and budget plans. Mr. Biden’s budget projections put real short-term interest rates around zero over the coming decade, and the real bond yield at around 1%.

Those assumptions reflect a belief that the factors holding down real rates before the pandemic, such as sluggish economic growth, aging, a surplus of global savings, and investors’ desire for safety, will resume. Markets seem to agree: Inflation-indexed bonds put the real 10-year bond yield at just 0.5% and see inflation plummeting to around 2% in a year from 9.1% in June. Markets see the Fed raising its target interest rate two more percentage points, to between 3.5% and 3.75%, by next spring and then cutting it.

But if inflation proves more stubborn, nominal and real rates will likely have to go much higher than this benign outlook implies. This is the first tightening cycle since the early 1990s when inflation started out well above the Fed’s objective. To push it back down would, in theory, require substantially positive real rates. What this means for the Fed’s short-term interest-rate target is unclear because it depends on where underlying inflation ends up once current energy and supply disruptions dissipate. Still, popular rules of thumb inspired by the economist John Taylor prescribe a nominal rate target of 7%, according to a June Fed report, about double current expectations.

That would be a rude awakening for markets. The Bank for International Settlements recently evaluated what would happen if advanced economy central banks raised their policy rates 4.25 percentage points, as much as the Fed tightened in 2004-2006. Housing and equity prices would both end up 5% lower, adjusted for inflation, in 2025 than now, and private-sector debt service would consume an additional 3% of income.

Federal budget math also gets ugly. In 2007 publicly held debt was 35% of GDP. A financial crisis, pandemic and two recessions later, it is 98%. But because bond yields have fallen from 5% then to 3% now, the cost of servicing that debt hasn’t increased. Furthermore, the Fed bought a lot of those bonds to hold down yields, remitting their interest back to Treasury. It paid for the bonds by issuing newly created electronic money, called reserves, to commercial banks, with an interest rate of close to zero.

It’s been a long time since rising interest rates forced Congress and the president into painful decisions on which spending to cut or taxes to raise. Thanks to higher inflation, they may face those decisions again.