The Fed should let Treasury yields rise and end its obsession with lower rates
Photo by Kenny Eliason on Unsplash
By Peter Morici
May 7, 2024 – First published at marketwatch.com
For too long, U.S. Federal Reserve policymakers have focused on when interest rates could be lowered to avoid a recession. Instead, economic growth and stock values over the long term would be better supported by letting markets take rates higher.
The consensus among Fed policymakers is that the federal funds rate should eventually fall to about 2.6% from its current 5.33% That target is higher than what prevailed between the 2008-2009 Great Financial Crisis (GFC) and the COVID-19 pandemic, but is still too low.
A better gauge for the adequacy of interest rates is the 10-year Treasury yield, which provides the benchmark for business and consumer borrowing rates. As of this writing, it’s about 4.5%.
The yield on high-quality corporate debt fluctuates between 0.7and 1.5 percentage points above that rate. It’s now trading closer to 0.7, anticipating that the Fed will eventually cut the federal funds rate and increase the availability of funds across all markets.
A good estimate of where the 10-year Treasury yield should be is the sum of expected inflation and economic growth — that’s currently in the neighborhood of 5% to 5.5%.
It’s worth recalling that in the 40 years prior to the financial crisis, average U.S. inflation was 4.0% and the 10-year Treasury yield averaged 7.4%. Yet stocks thrived —the S&P 500 SPX averaged a 10.5% return over that time. Nowadays, stocks again have held up well in the face of economic reports that put interest rate cuts further into the future.
Greater demands
The U.S. economy is emerging from a period of historically low inflation and interest rates. During the years between the GFC and COVID, globalization held down consumer prices, permitting the Fed to support households and businesses with easy money in the recovery from the economic downturn.
Demands on savings and spending are greater now. The Congressional Budget Office estimates that the U.S. federal deficit will rise to 6.1% of GDP in 2034 from 5.6% this year — much higher than the 4.6% figure in 2019.
Surging U.S. immigration is relieving labor supply constraints, but it requires more housing and other infrastructure and doesn’t bring a lot of additional capital. Investments in new technology, including artificial intelligence, electric vehicles and building a greener electrical grid, will tax available savings and put upward pressure on interest rates.
U.S. trend growth, in fact, is potentially much higher than the 1.8% Fed policymakers assume. For starters, AI is expected to boost productivity and investment; Goldman Sachs sees productivity gains of 1.5% annually.
More realistically, the attainable trend rate of economic growth should be closer to 2.8% than 1.8% if policymakers are not overzealous about suppressing inflation. Even former Fed Chair Paul Volcker only managed to get inflation down to an average 3.8% in the decade following the runaway inflation of the late 1970s and early 1980s.
Consumer expectations now for five-year inflation, as surveyed by the University of Michigan and New York Federal Reserve, are between 2.5% and 3%. Assuming inflation will be above 2.5% rather than 2% seems reasonable. Current Fed Chair Jerome Powell has said the central bank would tolerate periods of inflation above 2% to compensate for periods below 2%, but has mentioned little about the opposite circumstances.
Repairing the damage
One consequence from years of cheap credit is that weak firms that otherwise would have failed have managed to survive. This life support ties up labor, which instead should be focusing on new and expanding activities including AI-related infrastructure and software, electric vehicles, batteries and green energy.
Such damage to healthy capital reallocation is likely one reason the IMF study of more than 100 episodes across 56 countries found that central banks that lowered interest rates too soon after battling inflation endured both a resurgence of inflation and slower economic growth over the longer term.
If the Fed wants healthy economic growth, it should let the 10-year Treasury yield rise and abandon its obsession with lowering the federal funds rate to stave off a short recession. Not to do so threatens the country’s transition to an AI-led economy that will channel workers from mundane to more creative tasks,
Both economic growth and stocks would do well in that environment, as they did before the GFC, with a market-determined, realistic cost for capital. The Fed should let interest rates rise.
Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.
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Photo by Patricia Prudente on Unsplash
Don’t panic about China’s or America’s falling birthrates
By Peter Morici
May 23, 2023 – First published at Washington Times
China shocked the world earlier this year with news that its population fell in 2022, For the first time since the Maoist famines, deaths outnumbered births and the headcount slipped by 850,000 to a mere 1.41 trillion.
Analysts reactions range from a remembrance of how overpopulation fears in the West pressured Beijing into a one-child policy in 1979 to pronouncements that China’s economic decline has arrived.
Pundits lament that China will endure worker shortages, financial stress to support more older adults, and higher capital costs as resources are diverted to mitigate those challenges, but don’t wait for China’s collapse to eliminate it from the race for global supremacy.
The demographic clock is ticking for the West too. Birthrates are too low to sustain populations just about everywhere in advanced industrialized countries, and skilled workers are already scarce.
Challenges
Western governments face the challenges — currently a crisis in the United Kingdom — of financing investment in infrastructure and technology, maintaining living standards for working populations and paying pensions without running up unsustainable deficits.
That’s the crust of the debt ceiling problem here. Through a similar contraption — the Stability and Growth Pact — the European Union intended to limit deficit spending and cap accumulated national debts, but those limits are routinely violated and raised there too.
Cookbook progressive remedies — from subsidies to have babies to government-financed and industry-mandated child care — haven’t and won’t halt this inexorable disappearance of humanity.
Panic about apocalyptic trends and alchemists solutions plague civilization because the people who like to alarm us — tunnel-visioned academics and pundits — are captive to thinking about the world 25 or 50 years hence in terms of the technologies and social arrangements now or aspirations that fit their political agendas.
Until the early 19th century, economic growth was largely determined by population growth — the productivity gained by the wheel, three-part plough, etc., were gradual and absorbed into paying for the monuments and follies of religion and autocracy — cathedrals, palaces and armies.
Economic growth per capita
Only with the Age of Invention, Industrial Revolution and widespread development of modern capitalism and banking to hold money accountable for its uses did we see economic growth per capita take off and the emergence of a large empowered middle class — first in the West and now increasingly elsewhere.
At once, accelerating technological advancement and labor force growth determined economic growth, and nowadays we don’t need an ever-expanding or steady global population to live well and confront climate change, pandemics and the machinations of dictators.
The global headcount now stands at 8 billion and will peak above 10 billion late in this century. To raise the half of humanity living in poverty with the requisite goods and energy use and avert raising sea levels enough to sink Australia, two things appear certain: People have to work longer, and a smaller population consuming fewer resources would help.
The male retirement age, as defined by full government benefits in China, the U.S. and Europe, ranges between 60 and 67. Whenever a leader like French President Emmanuel Macron tries to raise it, all hell breaks loose. Progressives tell us how working longer may be fine for the Acela class doing corporate deals and sitting in front of computers, but cleaning ladies can’t be on their knees into their 70s.
Japanese faced the problems
The Japanese faced the problems of an aging population and declining workforce sooner and have sustained per-capita incomes by accepting immigrants from poorer nations, working smarter — redesigning physical tasks so that older workers could do them — and flexing their superior acumen with robotics. Those could beat the cleaning ladies’ arthritis too.
For the inexorably increasing share of workers in front of computer screens, problems with focus, memory and processing speed — some form of mental decline — caused by early-stage dementia is the challenge to working longer.
Until now, treatments have focused on removing plaque from the brain after dementia begins. But medical researchers are closing in on the equivalent of statins, which often cut off heart disease before it can develop, for the brain. We could take these medications in our 50s to keep us working at near top level well into our 70s.
In modern societies based on intellectual as opposed to physical labor, children cost too much to raise and educate. Once women start pursuing careersm those take on a priority beyond having three or even two children — one-child and childless marriages are becoming more prevalent.
Schools and universities simply take too long and use too many resources to educate the young. We need to bring forward vocational and professional training to start earlier in schools.
For example, law and medical training start earlier in the U.K. than here. For less demanding occupations, training and internships could be moved into the final two years of high school.
By extending the working life at each end, we can manage an aging population and prosper quite effectively.
