Don’t panic about the Fed (maybe)

The reason for this rout isn’t hard to see. With apologies to James Carville, “it’s the interest rates, stupid.”

The market fears rising interest rates. Those make today’s bonds less valuable, because who wants a 10-year contract paying, say, 1.5% a year (the interest rate on 10 year Treasury bonds at the start of the year) when new ones will pay 2.9% a year (the rate today)?

Those rising interest rates make stocks less valuable, too: Companies have to pay more for their debt, and stocks have to pay a higher return to compete with the higher (and safer) returns on bonds. This second point can also be rephrased in financial jargon terms of “discount rates.”

How bad will it get? Federal Funds—the benchmark short-term interest rates — are around 0.33% today. But various Fed officials are jawboning much higher rates, including possible hikes of 0.5% or even 0.75% at a time. The Fed will announce its next move this week. The money markets are predicting short-term rates will be around 3.5% in a year. Some number-crunchers at Deutsche Bank suggest they could go as high as 6%.

No wonder so many people are panicking.

No, I don’t know any different. Nor do I pretend to.

Everything useful about forecasts was said by the late, great Yankees manager Casey Stengel. Never make predictions, especially about the future.

But in this moment of alarm, I have to report that some smart people are making the case for the opposite point of view: Namely that these fears are overblown, interest rates won’t go anywhere near that high, and that the outlook for bonds (and stocks) may be much better than people think.

There are three arguments.

1. Rates have already risen much more than everyone realizes. That’s because so many market commentators are just talking about short-term interest rates, known as the fed-funds rate. But they are ignoring the massive amounts of liquidity that the Fed also pumped into the system during the crisis by purchasing bonds, so-called “quantitative easing,” and which it is now withdrawing. Solomon Tadesse, economist at SG Securities, says that when you combine the effects of the fed-funds rate and bond purchases you can calculate a real “shadow interest rate.” And, he estimates, this has already been hiked by 2.5 percentage points from a year ago. Based on history and current Fed plans, Tadesse estimates that short-term rates need only rise another 0.75 points or so to hit Fed tightening goals.

We can see the effects of this in the bond market already. Forget the minuscule 0.25% rise in the official short-term interest rate charged by the Fed. The interest rate on 10-year Treasury notes, the most important rate for pretty much everything, was just 0.55% in the summer of 2020. Today it is up to 3%, a sixfold increase. And the rate paid by BAA-rated U.S. companies — your basic investment grade blue chips — has rocketed by more than a third since December, from 3.3% to 4.7%. And the average interest rate on a 30-year fixed rate mortgage has doubled — yes, really — since early last year, and is now north of 5%. 

Rising interest rates have driven up the price of the U.S. dollar, which has risen 13% against other currencies in the past 12 months. That also slows the economy. It is bad for exports, bad for U.S. companies’ overseas earnings, and good for inflation. 

Worrying about interest rates rising today is like standing on the deck of Noah’s ark worrying about whether it’s going to rain. It’s already happened.

2. The Fed is raising rates to slow inflation, and that may already have peaked. The bond market hasn’t raised inflation forecasts for over a month. The five-year inflation forecast, which I’ve talked about here before, has actually been falling. Is the bond market wrong? I have no idea. But I have no reason to think it is.

A friend recently directed me to Allan Meltzer’s definitive history of the Federal Reserve. (And a rollicking read it is, too!) And especially to the events of 1973-4, which are similar in many ways to the situation today. That was the time of the first OPEC oil shock. Just like today (following Russia’s attack on Ukraine), a sudden shock sent U.S. fuel prices skyrocketing. Just like today, that added to inflation figures that were already rising. And, just like today, that caused a panic at the Federal Reserve and the markets.

But as Meltzer recounts, the Fed back then made a fundamental error. It confused a one-off jump in fuel prices, caused by an external oil shock, with inflationary pressures within the economy. An oil shock raises fuel prices and costs, but it is not the same as continuing inflation. On the contrary, it is deflationary. It is effectively a tax on consumers. So the OPEC price spike in late 1973 actually tumbled the U.S. economy into a recession, even while the Fed was misreading the signs and raising rates to stop inflation. It took months before the Fed had realized its mistake and reversed course. Meanwhile its rate hikes made a bad situation much worse.

Is the same thing happening today? Quite possibly. After all, we know for certain that three things have caused the recent rise in prices: Loose money during the pandemic, supply chain disruptions and shortages from all the lockdowns over the past two years, and oil and food shortages caused by the war in Ukraine. No sane person can deny the existence of all three factors. And that means some, possibly most, inflation is independent of the Fed. Extra tightening won’t help and will probably hurt.

Jason Furman, formerly chairman of Barack Obama’s Council of Economic Advisers and now an economics professor at Harvard’s Kennedy School of Government, wrote recently that inflation was either caused by a stronger-than-expected economic recovery from Covid or by supply-chain disruptions. Both, he said, cannot be true. I hesitate to disagree with an economics professor about economics, but I can’t agree with his logic. Both these things could be true at the same time, and surely they are. There has been a surge in demand as everyone has been finally released from Covid jail. But at the same time there are bizarre shortages caused by unprecedented supply chain disruptions. Those may take many months to resolve, especially with recurrent lockdowns like the recent one in China. But resolve they will.

3. How much can the U.S. economy handle higher interest rates anyway?

The surge in mortgage rates may not kill the real-estate market but it will surely cool it. Meanwhile business debts in the U.S. now total $18.5 trillion, according to the Federal Reserve. That’s a rise of more than 13% since before the pandemic, and twice the level it was before the 2008 financial crisis.

A decade or more of easy money and quantitative easing has left many U.S. companies with big debts and an unknown number among the ranks known as “zombie companies.” A zombie company is one that is the walking dead: It can only be kept upright by continuous infusions of cheap and easy money. (Think Japan after 1990, or underwater homeowners after the 2008 housing collapse.) There is genuine debate among economists about how many corporate zombies are walking around in the U.S. right now. One Federal Reserve paper said there were plenty. Another Fed paper, published two years later and after the pandemic crisis, suddenly said there weren’t that many after all. We shall see. Out of curiosity I ran a financial screen on FactSet of small U.S. publicly traded companies, those with market values between $300 million and $2 billion. Last year just 1 in 4 earned enough to pay the interest on its debts. That was before the recovery — but also before the rise in interest rates. It will be fascinating to see what happens to them, and the Russell 2000 small company index, if interest rates keep rising.

Bottom line? We’re hearing a lot from the people who are warning that inflation and interest rates are going much higher. But offer good reasons to think they might not be. The sensible rule for most of us, as usual, is: Be cautious, but don’t panic.