Thursday, January 25, 2018

On raising interest rates

One of the arguments for raising interest rates is that we need rates high enough that they can be cut when the next recession comes.

It seems to me anyone who makes that argument ought to admit in the same breath that it's raising interest rates that brings on recession. I don't know what to do about that, other than dismiss both the argument and the admission.

But I do know that the argument has been made. So suppose we take it at face value and say: Okay, how high do we want the interest rate to be? (Talking about the policy rate here, the Federal Funds rate.)

How high do we want the Federal Funds rate to be? I don't know the answer. But here's another question:

How high can rates go before they create another recession?

I don't know the answer to that one, either. But I know how high rates have been in the past. And I know that the trend of rates has been downhill since 1981.

And I'm pretty sure that the policy rate going up during 2004, 05, and 06 is what created the crisis of 07 and the recession of 08. Almost like the good old days (the 1970s) when the Federal Reserve created recession after recession on purpose to bring inflation down. And I'm pretty sure also that the policy rate going up, not in 1994 and 1995, but in 1999 and 2000 is what created the recession of 2001.

So when I make my interest rate trend line, I will omit data points for the peaks before the 2001 recession and the 2008 recession. Because I don't want to show what we have to do to create another recession. I want to show what we have to do to NOT create another recession.

Here's the graph:

Graph #1: The Federal Funds Rate and its High-Side Trend since the Peak
Looks like the Fed can safely raise interest rates to about 2%.


The Arthurian said...

The timing couldn't be better. Yesterday, Edward Harrison wrote:

"If you recall, a couple of weeks ago both Bill Gross and Jeff Gundlach, two of the most famous bond fund managers, spoke of the prospect of a bond bear market coming. And Bill Gross refined his call by writing how the bond bear had actually begun post-Brexit in 2016. Dalio is adding significantly to the bearish sentiment here, as he says explicitly that he agrees with Gross that the bottom for bond yields is behind us."

If the bottom for bond yields is behind us, then the trend line I show on my graph is no longer relevant. So the question becomes: What will the new trend look like? Is the Fed going to have to find out the hard way? Ouch!

"Dalio tells Schatzker that he expects the boom before the bust to last 12 to 18 months."

Harrison's view:

"My view: I am not convinced we are going to see a bond bear market, at least one that is long-lasting. And that’s because a bond bear market will necessarily negatively impact credit growth, precipitating a recession.

Well, if there was ever a time for Congress to change the policies that encourage debt accumulation into policies that discourage debt accumulation, this is the time.

We need to reduce the growth of debt. But cutting off new borrowing is the wrong approach. The better option, really, is to create tax incentives to accelerate the repayment of debt.

jim said...

"And I'm pretty sure that the policy rate going up during 2004, 05, and 06 is what created the crisis of 07 and the recession of 08."

You don't think the $6 trillion worth of mortgages that private investors funded through private channels had anything to do with the recession? Close to 100% of those loans were loans that never would have been made by traditional mortgage funding sources. In other words there ere $6 trillion in home sales that never would have happened without that huge influx of private money. That led to skyrocketing house prices and then collapse when they ran out of bad mortgages to underwrite. US home owner lost $6 trillion in hone equity in the collapse (that's averages to about $70,000 loss for each home owned). You don't think that might have something to do with the collapse in demand? To this day homeowners still have not recovered the lost home equity.

The Arthurian said...

You really think I'm ignoring debt, Jim? Me?

I'm trying to get past the point where I have to complicate things by assessing every possible possibility on every possible occasion.

The post is a glance at one aspect of interest rates.

jim said...

If your story about the Fed interest policy creating the 2008 crises is true then you should be praising the Fed.

In 2007 the private debt was growing at a rate of 4 trillion dollars per year and accelerating rapidly. If things had continued unchanged the private debt would have increased by at least another 100 trillion dollars by now. Instead it has hardly grown at all. You should be thanking the Fed.

Of course the Fed did nothing at all. The Fed rate policy has been passive for decades all they did was just followed the market's rate. The private debt binge blew itself up.

The Arthurian said...

NewDealDemocrat at Angry Bear, 30 Jan:

"As of this morning, conventional 30 year mortgage rates are 4.28%, about 0.10% below their 52 week high of 4.38%.
Housing stalled for several quarters last year in the face of a 1% increase in mortgage rates, and slowed down even more in 2014 when mortgage rates rose 1.4% off their bottom. If mortgage rates hit 4.4% and stay above that level for several months, I expect another housing slowdown to begin, although given the demographic tailwind from the Millennial generation, I wouldn’t expect an outright downturn in housing unless mortgage rates rise all the way to about 5%.

5% for a housing crunch, NDD thinks. So something over 5% for recession. Five and a half, maybe six.

I think my 2% is low, but I also think 6% is too high to be realistic. But it depends on the vigor the economy shows. It it's weak, recession will come at a low interest rate. If it's strong, at a high rate.

On an unrelated note, I see that NDD expects downturn to result when interest rates reach some critical level. So do I. For a different perspective see the comments at Reddit.

The Arthurian said...

Me: "One of the arguments for raising interest rates is that we need rates high enough that they can be cut when the next recession comes."

Real-Time Estimates of Potential GDP: Should the Fed Really Be Hitting the Brakes? by Coibion, Gorodnichenko, & Ulate:

"Policymakers at the Federal Reserve responded aggressively to the financial crash. But they now seem to be in a rush to return to a more traditional policy-making environment and give themselves ammunition in the form of higher interest rates for the next recession."

... I still say we need tax incentives to accelerate the repayment of debt. Accelerated Repayment would reduce the urgency of need to raise rates.

And it slows the growth of private debt.

It is a way to fight inflation, a better way than raising rates.

jim said...

"I still say we need tax incentives to accelerate the repayment of debt. Accelerated Repayment would reduce the urgency of need to raise rates. "

The Fed has no urgency to raise rates. If market rates start to fall the Fed will lower its rates.

There are 2 fundamental problems with that statement:

A] You haven't explained how it would work in detail

B] The private debt binge that preceded the crash was a period of Accelerated Repayment. Of the $6 trillion worth of mortgages funded through almost $4T were already repaid. There is no evidence that accelerated repayment will reduce private debt. History shows it can be a powerful engine for pushing private debt higher

The Arthurian said...

At the St. Louis Fed On the Economy blog, August 2017, The Fed Funds Rate and Low Long-Term Interest Rates:

“The median projection of FOMC participants is 2.1 percent and 2.9 percent by the end of 2018 and 2019, respectively, which is close to the long-term yield”

The article says the level of long-term rates helps establish the upper limit for short-term rates.

I said 2.0. They say 2.1 in a year, 2.9 in two years.
We're not far apart.

The Arthurian said...

Tim Duy, 4 Feb 2018:

"I don’t see ten-year yields jumping to 4 percent and instead expect much more resistance as 3 percent is crossed."

A little over 3% for ten-year rates.
Obviously lower for short term rates. Perhaps around 2%?

The Arthurian said...

FRED Blog, 19 April 2018:
"But what is the “normal” interest rate? Some people are arguing that it’s actually lower than what it has been before. One way to try to identify this normal state is by looking at long-term trends in interest rates: Presumably, long-term forces are what move the normal level of interest rates."

More or less what I was looking at in the post.

The Arthurian said...

John C. Williams, 21 May 2018:
"My own view is that r-star today is around 0.5%. Assuming inflation is running at our goal of 2%, that means the typical, or normal short-term interest rate is 2.5%. For comparison, the median longer-run value of the federal funds rate in the Federal Open Market Committee’s (FOMC’s) most recent economic projections is 2.875% (Board of Governors 2018b)."

The Arthurian said...

I linked this post at Reddit a year back. Got a lot of negative comments related to my statement that "it's raising interest rates that brings on recession."

One guy said: "So if we never raise rates then the next recession will never be triggered right?"

Another said: "Clearly if we look at the economy before the Fed was established it never went into recessions!"

Another: "This blog post asserts that since interest rates are lowered to counter a recession, that must mean that high interest rates are the cause of recessions. I don't even know where to begin with how idiotic this is."

Whatever. Today I read Dean Baker in Will Degrowthing Save the Planet?, saying:
"The Federal Reserve Board has brought on nine recessions since World War II."

That's a supercharged version of what I said. Same, but stronger and more specific. For the record.

The Arthurian said...

John Hussman, February 2019:
Back on October 3, Powell alarmed investors, I suspect inadvertently, when he communicated the Fed’s efforts to normalize interest rates using these words:

“The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore. Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point.”

Powell walked that statement back on November 28, when he described the position of rates as “just below” neutral. Following an additional rate hike by the Fed in December, Powell noted on December 20 that “We have reached the bottom end of the range of committee estimates of what might be neutral. I think from this point forward, we are going to let the data speak to us and inform the outlook.”

Dated 21 December 2018 on the FRED graph, the lower and upper limits of the Federal Funds Target Range are shown at 2.25% and 2.50%.

A year back I said "Looks like the Fed can safely raise interest rates to about 2%." That was based only on lines on a graph.

Abhi said...

good article