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An NYT article on the stock market’s plunge also noted that the yield curve, defined as the gap between the interest rate on 10-year Treasury bonds and two-year notes, is close to being inverted. The interest rate on 10-year bonds was just 0.12 percentage points higher than the interest rate on 2-year notes. The piece points out that an inverted yield curve has historically been associated with a recession in the near future.
While I would not rule out a recession (we will have another recession someday), I am less impressed by this signal than the NYT. The longer-term rates tend to follow the expected path of the short-term rate with a longer yield providing a greater premium since the holder of a long-term bond suffers a substantial capital loss if the price goes down.
For example, if I’m holding a 10-year Treasury bond and the interest rate increases from 3.0 percent to 4.0 percent in a relatively short period of time, the price would fall by close to 9.0 percent. To cover that risk, I will want a premium over the short-term rate. The same logic applies to a 2-year note, except that the potential loss from a rise in interest rates is much smaller so the necessary premium is much smaller.
However, the risk in this story is that the Federal Reserve Board will raise interest rates. Currently, the federal funds rate is at 2.25 percent. While there is a good chance the Fed will raise rates by 0.25 percentage points at its meeting this month, Fed Chair Jerome Powell has made it clear that he thinks we are near the end of a cycle of rising rates. For this reason, holders of longer-term debt have less reason to fear that short-term rates will rise much from their current level. Therefore, they are not demanding large risk premiums.
Historically, we have reached this point where investors no longer saw much risk of further rate hikes after a period of aggressive rate increases by the Fed. In 1989, the peak of the federal funds rate was almost 4.0 percentage points above its cyclical low. In the mid-1970s, it was more than 8.0 percentage points, and in 1980 the federal funds rate peaked more than 14.0 percentage points above the low for the cycle.
When the Fed engages in an aggressive round of rate hikes, it is reasonable to bet we will see a recession. In this case, the Fed has been much more modest in its rate increases. While there is little doubt that the rate hikes are having an effect in slowing the economy — housing has been hit hard and the rise in the dollar is causing the trade deficit to rise — these sources of weakness do not seem sufficient to throw the economy into a recession, even if the yield curve does invert.
Note: I had earlier put the loss on a 10-year Treasury bond from a rise in the interest rate at 8.0 percent. Joe Emersberger corrected the mistake.
An NYT article on the stock market’s plunge also noted that the yield curve, defined as the gap between the interest rate on 10-year Treasury bonds and two-year notes, is close to being inverted. The interest rate on 10-year bonds was just 0.12 percentage points higher than the interest rate on 2-year notes. The piece points out that an inverted yield curve has historically been associated with a recession in the near future.
While I would not rule out a recession (we will have another recession someday), I am less impressed by this signal than the NYT. The longer-term rates tend to follow the expected path of the short-term rate with a longer yield providing a greater premium since the holder of a long-term bond suffers a substantial capital loss if the price goes down.
For example, if I’m holding a 10-year Treasury bond and the interest rate increases from 3.0 percent to 4.0 percent in a relatively short period of time, the price would fall by close to 9.0 percent. To cover that risk, I will want a premium over the short-term rate. The same logic applies to a 2-year note, except that the potential loss from a rise in interest rates is much smaller so the necessary premium is much smaller.
However, the risk in this story is that the Federal Reserve Board will raise interest rates. Currently, the federal funds rate is at 2.25 percent. While there is a good chance the Fed will raise rates by 0.25 percentage points at its meeting this month, Fed Chair Jerome Powell has made it clear that he thinks we are near the end of a cycle of rising rates. For this reason, holders of longer-term debt have less reason to fear that short-term rates will rise much from their current level. Therefore, they are not demanding large risk premiums.
Historically, we have reached this point where investors no longer saw much risk of further rate hikes after a period of aggressive rate increases by the Fed. In 1989, the peak of the federal funds rate was almost 4.0 percentage points above its cyclical low. In the mid-1970s, it was more than 8.0 percentage points, and in 1980 the federal funds rate peaked more than 14.0 percentage points above the low for the cycle.
When the Fed engages in an aggressive round of rate hikes, it is reasonable to bet we will see a recession. In this case, the Fed has been much more modest in its rate increases. While there is little doubt that the rate hikes are having an effect in slowing the economy — housing has been hit hard and the rise in the dollar is causing the trade deficit to rise — these sources of weakness do not seem sufficient to throw the economy into a recession, even if the yield curve does invert.
Note: I had earlier put the loss on a 10-year Treasury bond from a rise in the interest rate at 8.0 percent. Joe Emersberger corrected the mistake.
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My friend, Jared Bernstein, laid out the case for a pause in the Fed’s interest rate hikes at its meeting this month. I agree with pretty much everything Jared said, but want to push one point a bit further.
Jared raises the argument made by the more hawkish types that we have well-anchored inflationary expectations that we don’t want to risk losing by allowing inflation to accelerate. This line is given as a rationale for hiking interest rates in a context where inflation even now is under the Fed’s 2.0 percent target. And, this target is, of course, an average, meaning that to be consistent with the target we must have some periods with inflation above 2.0 percent.
Note how the threat we are supposed to fear has been pushed back. It is not actual inflation, that we are supposed to fear, or even potential inflation, which we have no reason to expect to jump in response to modest further reductions in the unemployment rate, it is now expectations that we should worry will become unanchored. This is getting pretty far removed from anything we see in the real world and very much into metaphysical land.
While there is nothing wrong with metaphysical speculation in many contexts, this is not one of them. We know that higher interest rates will slow the economy and keep people from getting jobs. The losers in this story are the most disadvantaged in society, blacks, Hispanics, people with less education, and others who face discrimination in the labor market.
To my view, the Fed has an absolute duty to push the unemployment rate as low as it can go until we see real evidence of inflationary pressures. Any honest economist has to admit we don’t know what this level is. Just five years ago, the median estimate at the Fed was 5.4 percent. That clearly was wrong. I would have said something like 4.0 percent, but even this now looks too high.
The unemployment rate looks likely to get still lower in the months ahead, probably crossing 3.5 percent and likely getting lower. Can it hit 3.0 percent? I don’t know, but let’s see what happens if we try. The potential benefits are enormous and the downsides are shall we say, speculative.
My friend, Jared Bernstein, laid out the case for a pause in the Fed’s interest rate hikes at its meeting this month. I agree with pretty much everything Jared said, but want to push one point a bit further.
Jared raises the argument made by the more hawkish types that we have well-anchored inflationary expectations that we don’t want to risk losing by allowing inflation to accelerate. This line is given as a rationale for hiking interest rates in a context where inflation even now is under the Fed’s 2.0 percent target. And, this target is, of course, an average, meaning that to be consistent with the target we must have some periods with inflation above 2.0 percent.
Note how the threat we are supposed to fear has been pushed back. It is not actual inflation, that we are supposed to fear, or even potential inflation, which we have no reason to expect to jump in response to modest further reductions in the unemployment rate, it is now expectations that we should worry will become unanchored. This is getting pretty far removed from anything we see in the real world and very much into metaphysical land.
While there is nothing wrong with metaphysical speculation in many contexts, this is not one of them. We know that higher interest rates will slow the economy and keep people from getting jobs. The losers in this story are the most disadvantaged in society, blacks, Hispanics, people with less education, and others who face discrimination in the labor market.
To my view, the Fed has an absolute duty to push the unemployment rate as low as it can go until we see real evidence of inflationary pressures. Any honest economist has to admit we don’t know what this level is. Just five years ago, the median estimate at the Fed was 5.4 percent. That clearly was wrong. I would have said something like 4.0 percent, but even this now looks too high.
The unemployment rate looks likely to get still lower in the months ahead, probably crossing 3.5 percent and likely getting lower. Can it hit 3.0 percent? I don’t know, but let’s see what happens if we try. The potential benefits are enormous and the downsides are shall we say, speculative.
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In the middle of a useful article on the trade deficit, the Post told readers:
“Last year’s $1.5 trillion Republican cut in corporate and personal income taxes, along with the decision to eliminate congressional limits on government spending, has revved up the economy and created nearly $1 trillion budget deficits for the coming years that require financing from abroad.”
This is not exactly true.
When the government borrows more money, it pushes upward pressure on interest rates, other things equal. At higher interest rates, foreign investors may choose to buy more US government bonds, but it is also possible that domestic investors will opt to buy more US bonds, as opposed to other assets. This is the reason that interest rates on mortgages and corporate debt have risen in the last year. Investors who might have otherwise held these assets are instead choosing to buy government bonds.
If no foreigners opted to buy the newly issued debt, interest rates would rise to the point where enough US investors were willing to hold the debt. The fact that foreigners are willing to buy US bonds means that interest rates would not rise as much as would otherwise be the case (holding the response of the Fed constant), but the US does not need foreigners to buy our debt.
In the middle of a useful article on the trade deficit, the Post told readers:
“Last year’s $1.5 trillion Republican cut in corporate and personal income taxes, along with the decision to eliminate congressional limits on government spending, has revved up the economy and created nearly $1 trillion budget deficits for the coming years that require financing from abroad.”
This is not exactly true.
When the government borrows more money, it pushes upward pressure on interest rates, other things equal. At higher interest rates, foreign investors may choose to buy more US government bonds, but it is also possible that domestic investors will opt to buy more US bonds, as opposed to other assets. This is the reason that interest rates on mortgages and corporate debt have risen in the last year. Investors who might have otherwise held these assets are instead choosing to buy government bonds.
If no foreigners opted to buy the newly issued debt, interest rates would rise to the point where enough US investors were willing to hold the debt. The fact that foreigners are willing to buy US bonds means that interest rates would not rise as much as would otherwise be the case (holding the response of the Fed constant), but the US does not need foreigners to buy our debt.
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The Washington Post told readers that when the deficit figures for 2018 were released last month:
“The announcement unnerved Republicans and investors, helping fuel a big sell-off in the stock market.”
The claimed impact on the market seems implausible. In April, after analyzing the effect of the tax cuts, the Congressional Budget Office (CBO) projected the deficit for the 2018 fiscal year would be $804 billion. The figure for the deficit that was reported last month was $779 billion, $25 billion less than what CBO had projected six months earlier. It is hard to believe that a deficit that was slightly lower than projected could cause a big sell-off in the stock market.
It is also worth noting that this piece makes zero effort to put any numbers in context. Since almost none of the Post’s readers has any idea of the meaning of the deficit and debt numbers used in the piece, it is difficult to see why they would use them. It is not hard to express these numbers as a share of GDP and relative to the size of past deficits, measured as a share of GDP. In fact, CBO actually expressed the deficits and debt as shares of GDP in its report, so it is not even necessary to do the arithmetic.
The Washington Post told readers that when the deficit figures for 2018 were released last month:
“The announcement unnerved Republicans and investors, helping fuel a big sell-off in the stock market.”
The claimed impact on the market seems implausible. In April, after analyzing the effect of the tax cuts, the Congressional Budget Office (CBO) projected the deficit for the 2018 fiscal year would be $804 billion. The figure for the deficit that was reported last month was $779 billion, $25 billion less than what CBO had projected six months earlier. It is hard to believe that a deficit that was slightly lower than projected could cause a big sell-off in the stock market.
It is also worth noting that this piece makes zero effort to put any numbers in context. Since almost none of the Post’s readers has any idea of the meaning of the deficit and debt numbers used in the piece, it is difficult to see why they would use them. It is not hard to express these numbers as a share of GDP and relative to the size of past deficits, measured as a share of GDP. In fact, CBO actually expressed the deficits and debt as shares of GDP in its report, so it is not even necessary to do the arithmetic.
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The media have been touting a new foreign aid initiative by the Trump administration which will create an agency that will provide $60 billion worth of loans, loan guarantees, and insurance for investments in developing countries. This is portrayed as an effort to counter China’s growing influence in the developing world.
It would have been helpful to put this number in some context. First, if this is an effort to counter China, it is likely to come up short. China has already paid out more than $900 billion as part of its “One Belt, One Road” initiative. Presumably, its spending will increase in this area in the decade ahead.
The second point is that news articles should put the number in some context for readers who are concerned that all their tax dollars are going to foreign aid. This money is being dispensed to subsidize loans, guarantees, and insurance. It is not a handout. If we assume that 20 percent of the money is a subsidy (i.e. allowing below market rates), this would amount to $12 billion. That would come to a bit more than 0.2 percent of federal spending, at the point where it reaches the $60 billion mark, presumably in around five years.
Note: This is corrected from an earlier version, which did not treat the $12 billion as an annual subsidy.
The media have been touting a new foreign aid initiative by the Trump administration which will create an agency that will provide $60 billion worth of loans, loan guarantees, and insurance for investments in developing countries. This is portrayed as an effort to counter China’s growing influence in the developing world.
It would have been helpful to put this number in some context. First, if this is an effort to counter China, it is likely to come up short. China has already paid out more than $900 billion as part of its “One Belt, One Road” initiative. Presumably, its spending will increase in this area in the decade ahead.
The second point is that news articles should put the number in some context for readers who are concerned that all their tax dollars are going to foreign aid. This money is being dispensed to subsidize loans, guarantees, and insurance. It is not a handout. If we assume that 20 percent of the money is a subsidy (i.e. allowing below market rates), this would amount to $12 billion. That would come to a bit more than 0.2 percent of federal spending, at the point where it reaches the $60 billion mark, presumably in around five years.
Note: This is corrected from an earlier version, which did not treat the $12 billion as an annual subsidy.
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