Federal Reserve to “Normalize” Interest Rates

Recently there has been much discussion regarding the Federal Reserve’s policy of Interest Rate Normalization.  The Fed has raised the Fed Funds Rate seven times from ½% in December 2015 to 2.25% in September of this year with indications of more to come.

The goal of the Federal Reserve is to raise short term interest rates gradually to the Neutral Rate of Interest.  The Neutral Rate of Interest as defined by Federal Reserve Board member Lael Brainard is “Intuitively, I think of the nominal neutral interest rate as the level of the federal funds rate that keeps output growing around its potential rate in an environment of full employment and stable inflation.”

In a recent speech Lael Brainard goes on to explain that while there are shorter run Neutral Interest Rates which fluctuate with current economic conditions, the long run Equilibrium Neutral Rate “generally refers to the output growing at its longer-run trend, after transitory forces reflecting headwinds or tailwinds have played out, in an environment of full employment and inflation running at the FOMC objective” The FOMC inflation rate objective has been 2% since 2008.

 The Equilibrium Neutral Rate is not directly observable, so it must be estimated or inferred from the movements of variables that are observed, such as market interest rates, inflation, the unemployment rate, and GDP.  The Federal Reserve Board of Governors estimates this rate to be in the range of 2.5% to 3.5% in nominal terms. This level of Equilibrium Neutral Rate provides ample room for further Federal Funds rate increases in 2018 and 2019.

What does Normalization Mean for Longer Term Interest Rates?

On October 1th Federal Reserve Chairman Jerome Powell made the following comment at the Atlantic Festival, “The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore.”  He went on to say, “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.” The reaction of the markets was swift and dramatic. The 10-year Treasury note rose from 3.06% on Tuesday, October 2nd to 3.23% on Friday, October 5th, its highest yield since 2011.

Since short term rates may rise to Neutral of 2.5% to 3.5% or more, we can expect long term investors to lift their required yield rates to maintain a Normal Yield Curve. According to Investopedia, “The normal yield curve is a yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. This gives the yield curve an upward slope. This is the most often seen yield curve shape, and it’s sometimes referred to as the “positive yield curve””

 Long Term Interest Rate Rule of Thumb

There is a close relationship between the yield on the ten year US Government Treasury Bond rate and the US national nominal GNP as show below.

10 Year Bond Yield vs Nominal GDP Growth

Since 1953, the US Treasury 10-Year Bond Yield has approximated the yearly per cent change in the Nominal GDP.  Real GDP growth in the 1st quarter of 2018 was 2.2% and in the 2nd quarter was 4.2%.  Estimates for the year are about 3.0%.  This rate of real growth plus the Federal Reserve’s inflation target of 2% imply a Nominal GDP for 2018 of 5.0% and eventually a corresponding rise in ten year Treasury securities.

 While the relationship between Nominal GDP and 10-Year US Treasury securities is not precise, there is ample evidence to conclude that long term rates will rise as the economy continues to grow.

Federal Reserve to “Normalize” Balance Sheet

Long term rates will rise not only due to inflation which is now running at 2.3% (PCE Deflator) and robust growth, but also from an unwinding of QE stimulus by the Federal Reserve. The phrase “unwinding” is often used because of the slow and gradual nature of reducing the Fed’s balance sheet. St. Louis Fed Research Director Chris Waller recently compared it to slowly opening the stopper in a drain and letting water run out.

In a May 2018 Dialogue with the Fed presentation, Waller explained that the Fed is taking a capped, controlled approach to unwinding its balance sheet: letting Treasury securities “run off” at about $6 billion a month and letting mortgage-backed securities run off at about $4 billion a month. “And then it’s going to increase at every three months,” he said, “to where there’s a maximum of $30 billion a month in Treasuries running off, and $20 billion a month in mortgage-backed securities” running off.

The Fed - balance sheet chart

Unwinding of the stimulus held in bank excess reserves at the Fed will raise short and medium term (3-7 year) interest rates pushing long bond buyers to demand higher rates for 10 year securities.

Since tax exempt municipal bond rates follow Treasury rates as shown below,


20 Yr T vs 20 Yr Muni

both Treasury securities and tax exempt rates should rise in 2019 with significant increases in 2020 and beyond.  Current long term Treasury rates are a bargain given the probability that they will rise in the near future. The reduction of the Federal Reserve’s balance sheet along with low and negative interest rates in Europe and Japan has depressed the US long term rates. This condition cannot last. 

The Federal Reserve is expected to reduce their balance sheet to about $3.0 trillion from the current $4.0 trillion through reductions of $50 billion/month.  At this rate the balance sheet should be reduced to the desired amount in about 20 months, sometime in 2020. Both Europe and Japan will eventually raise their interest rates as their economies recover from the Great Recession.  The European Central Bank has completed their QE and is expected to begin normalization of their interest rates and balance sheet in 2019. Japan will follow. The completion of QE is a signal to markets that growth in the underlying economy is now underway.

Midwest Credit Lease LLC can help you take advantage of current low long term interest rates through a CTL loan that will be easy to execute, low cost, and flexible enough to meet your needs.  We can provide both permanent financing and construction/permanent financing.

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