The conventional wisdom is that the Fed has the power and ability to control both the inflation rate and bond yields. Yet, if that is the case, what explains the current economic environment? It is an unusual one that has many investors worried and confused regarding the future path of the inflation rate and bond yields. The next few paragraphs review a few concepts that help us understand their reasoning and allow us to reach our own conclusions regarding the outlook.
But before we delve into those concepts, let’s refresh our memory as to the relationship between bond yields and inflation – the Fisher equation. The Fisher equation states that the real interest rate, r, is equal to the nominal interest rate, i, minus inflation, π.
r = i – π
As an investor, bond yields are a proxy for nominal interest rates today. The real interest rate is the difference between nominal rates and inflation. Let’s keep that in mind as we work through our framework in order to decipher where real interest rates are headed.
Deficits and Interest rates
A commonly held view is that increasing deficits increase bond yields. The logic goes, that the sale of government bonds to the public to finance a government budget deficit, results in an outward shift in the bonds supply curve (i.e., an increase in the quantity of bonds). Standard demand and supply analysis suggests that an increase in quantity, all else the same, results in a decline in the price of the government bonds. Since the price of bonds moves inversely to their yields, this analysis points to a positive correlation between deficit financing and government bond yields (i.e., nominal interest rates); deficit goes up, and bond yields go up. We will call this the “crowding out” hypothesis because as the government’s bond issuances increase bond yields it makes borrowing more expensive and reduces participation from the private sector.
There is an alternate view that yields a different conclusion. A couple of centuries ago economist David Ricardo argued that in a forward-looking world, taxpayers realize that deficit financing implies a higher future tax liability. Ricardo argued that if the current taxpayers cared about the future generations, i.e., their descendants, the current taxpayers would act to offset or reverse the future tax burden increase. The current taxpayers would essentially help out their future heirs by increasing their current savings rate in order to leave a bequest large enough so that their descendants would be able to pay the taxes associated with the current deficits. As investors, bonds are the saving mechanism of choice for steady, predictable cash flow, so Ricardo argued that there would be an increase in demand for bonds. If this increase in savings matches the increase in supply generated by the bonds issued to finance the deficit, the price of the bonds remains unchanged (hence no price or yield change) while the quantity of bonds transacted increases by the amount of the deficit. This is the so-called Ricardian equivalence which yields the forecast that budget deficits are uncorrelated to interest rates; deficits go up, with no impact on bond yields.
The Ricardian equivalence yields a vastly different forecast regarding the impact of budget deficits than the forecast made by the initial hypothesis. But which one is correct?
The relationship between deficits and interest rates depends on a few things. How much of the deficit is financed by the sale of government bonds to the public markets? Will investors anticipate a future tax burden? Do they care enough about future generations in order to offset their future tax liability by increasing their savings today? Although there is a strong belief that the deficit causes higher interest rates, the empirical evidence is not as strong as the advocates of this theory believe. To paraphrase the administration, we follow the data and our reading of the data points to a lack of correlation.
Now that this has given us some insight as to how fiscal policy might impact nominal interest rates (the i in our Fisher equation), we move on to inflation.
Deficit, inflation, and the Phillips Curve
The Phillips Curve, put simply, posits that as the economy approaches full employment, price increases accelerate (i.e., inflation). A decline in the unemployment rate also results in an increase in output or GDP. Thus, the Phillips Curves posits a positive correlation between real GDP and inflation.
How do budget deficits interact with the Phillips Curve? Textbook Keynesian economics teaches us that an increase in deficit spending results in an increase in the economy’s aggregate demand resulting in a higher output, lower unemployment, and higher inflation. Notice that this requires two assumptions. That the Phillips Curve relationship and the “Crowding out” hypothesis both holds. If that is the case, an increase in government expenditures and/or deficit financing leads to a higher output and inflation. This is the point that some critics of the Biden administration are pointing out, we believe, incorrectly.
The Phillips Curve interpretation leads one to believe that one must choose between inflation and real GDP growth. But there are other possibilities and President Biden has correctly identified them – the supply side. An increase in the economy’s aggregate supply leads to a correlation that is the opposite of the one posited by the Phillips Curve; an increase in output leads to a decrease in inflation.
We agree with the President’s argument. However, we have a different view of the policies needed to stimulate the economy’s aggregate supply. The Biden administration argues that Build Back Better (BBB) will increase the aggregate supply, yet we contend that BBB is mostly an aggregate demand policy, heavy on income redistribution and regulations. One only needs to point to the additional $300 a week unemployment benefits enacted at the beginning of the pandemic, the cancelation of the Keystone XL pipeline, and other regulations making it more difficult to produce energy. These policies reduce the incentives to work, invest and produce thereby restricting output. As far as the aggregate supply is concerned, the policies proposed by the administration go the wrong way. If our analysis of BBB is correct, a policy that increases aggregate demand while decreasing the aggregate supply could have a devastating effect on prices and the inflation rate. The Phillips curve attempts to link the real economy and inflation, but as we have always stated, inflation is a monetary phenomenon, so next we take a look at the banking system and its role in creating the current environment.
Budget deficits, the Fed balance sheet, and the monetary base
Inflation is too much money chasing too few goods, thus making it a monetary phenomenon. Just like with any other good, when the supply or demand for that good shifts, we may see a change in price; money is no different. Too much supply of money, with not enough demand for money, is another way of expressing our previous statement. This sets up our analysis of the monetary system as a supply and demand analysis. We will tackle the supply of money first.
The Federal Reserve’s board of governors’ job is to keep the supply and demand of money in balance (and hence control inflation) through monetary policy. There are several key variables that the Fed can manipulate in its attempt to control inflation: the quantity of money and the monetary base. The quantity of money circulating in the economy is known as M2, and the Fed plays a vital role in the determination of that quantity.
The Fed uses two main levers in order to affect M2 – the monetary base and the money multiplier. Let’s first start with the monetary base, which is the number of greenbacks that are issued and circulating in the economy (the orange circle in Figure 1). It is a key variable affecting M2. The monetary base has two components: Bank Reserves and currency in circulation, i.e., greenbacks. The Fed can manipulate the monetary base by conducting open market operations. When the Fed wants to increase the monetary base, it buys bonds in the open market and prints money to pay for the bonds. When it wants to reduce the monetary base, it sells bonds in the open market and receives cash in return, taking cash out of circulation. Double-entry bookkeeping means that the monetary base exactly matches the assets held by the Fed, i.e., the balance sheet. An expansion of the Fed balance sheet means an increase in the monetary base while a reduction in the Fed balance sheet means a decrease in the monetary base.
The monetary base’s second use is as reserves held by the banking system, backing the deposits held at banks (i.e., demand deposits). The fractional reserve banking system links the reserves to the demand deposits and thus the quantity of money (i.e., cash plus demand deposits). The banking system’s double-entry bookkeeping ensures that the assets of the banking system, the reserves plus the loans the banks make, add up to the liabilities of the banking system, i.e., the deposits held at the bank.
Another lever through which the Fed can alter the quantity of money is through the money multiplier via capital adequacy rules – the ability to mandate the reserve requirements banks must hold in order to back up demand deposits. The Fed can also pay interest on reserves, and use its moral suasion and/or threat of regulations in order to alter banks’ behavior. Collectively these actions affect commercial banks’ deposit, loan creation, and thus the composition of the assets and liabilities held by the bank. In effect, the Fed can limit the banking system leverage factor or money and credit multiplier. That is the Fed can impact the deposits and loans created by $1 worth of bank reserves.
Jointly, the monetary base and the money multiplier determine the quantity of money, M2. Judging by its record during most of the last four decades, the Fed has been an independent organization mostly focused on delivering a 2% inflation rate. However, the Financial Crisis marked a turning point for the Fed. In order to prevent a financial meltdown, the Fed expanded its balance sheet to provide liquidity to the economy. It was the right policy. It was supposed to be a temporary balance sheet expansion, but the reduction never materialized. The Fed ended up financing significant portions of the budget deficit and in the process, the Fed changed its operating procedures to accommodate the deficit financed spending of the Federal government. But more importantly, in doing so the Fed subjugated its independence and became the financing arm of the US Treasury. In the process, the Fed relinquished control of the monetary base, the major lever it had at its disposal to influence and/or control the quantity of money. A process of elimination leads us to conclude the other levers (namely the money multiplier) would have to work overtime in order to achieve the Fed’s monetary objectives. The Pandemic suggests that the other levers were not enough to prevent the surge in the inflation rate.
But M2 is only half of the inflation story. An accurate forecast needs to account for the demand for money. Monetary theory tells us that the demand for money depends on the real GDP growth and the velocity of money. This discussion suggests that there are four key drivers of the excess money supply: two supply components – the monetary base and money multiplier – and two demand components – real GDP growth and the velocity of money. These four components guide our expectations of future inflation.
However, the Fed does have a few more tricks up its sleeve when it comes to bringing inflation down.
The Fed and the banks credit creation
When people talk about the Fed raising interest rates, they’re referring to the federal funds target rate. Set by the Federal Open Market Committee (FOMC) at its regular meetings, the fed funds target rate acts as a reference for the interest rates big commercial banks charge each other for overnight loans. Banks borrow overnight loans to satisfy liquidity requirements set by regulators, including the Fed. The average of the rates banks negotiate for overnight loans is called the effective federal funds rate. This in turn impacts other market rates, like the prime rate.
When the Fed raises the federal funds target rate, the goal is to increase the cost of credit throughout the economy. Given the monetary base, the only way this can happen is by reducing the money multiplier or leverage factor of the banking system. By reducing banks’ credit creation (the money multiplier), less money and credit are being created per dollar worth of monetary base. The reduced bank credit creation makes loans scarcer for both businesses and consumers, and everyone ends up spending more on interest payments. The Fed then has to ask themselves, what increase in interest rates is needed and over what period? Should the Fed increase rates by 50 or 75 basis points increments? Will one or two increases be enough? We got our answer to the basis point question last week. What remains now is how many increases. Aside from the increase in borrowing costs caused by these activities, there is the additional impact from the rate increase on the real economic growth rate.
Putting it all together
As already mentioned, some economists argue that the budget deficits crowd out private sector lending by increasing borrowing costs. The Ricardian equivalence argues that there is no crowding out, in which case the crowding-out view leads to an overestimate of the increase in interest rates. But there is more to the deficit financing story. To the extent that the Fed accommodated the budget deficit, i.e., financed the US Treasury deficit, the financing resulted in a dramatic expansion of the Fed balance sheet. All else the same, the balance sheet expansion results in a corresponding increase in M2. To prevent excess money growth the Fed took measures to reduce the money multiplier to offset the impact of the balance sheet expansion partially or completely on M2. Early on, the Fed was successful in this endeavor. However, the persistent deficit means a persistent expansion of the balance sheet and that means it would become increasingly more difficult for the Fed to reduce the money multiplier and offset the increase in the monetary base. The persistent balance sheet expansion led to an excess money supply and a surge in the inflation rate.
The inflation rate surge has been a wake-up call for the Fed. In response, it recently announced a gradual reduction in its balance sheet. We believe this to be great news for a couple of reasons. First, the reduction in the balance sheet will slow down the monetary base growth rate and, all else the same, result in a lower inflation rate. Longer-term, the outlook is also quite bullish. The announcement signals that the Fed is on its way to becoming independent once again. This should facilitate a return to the long-run Disinflation produced by the Volker price rule.
The interest rate side is a bit more complicated. The Fed tightening and interest rate hikes should result in a reduction in the money multiplier, an excess demand for bank credit, and thus an increase in the price of bank credit. Then there is the effect of the regulatory policies and disincentives generated by the BBB policies. We contend that BBB will adversely affect the economy’s supply side and cause slower economic growth, which means a lower real interest rate. Several of these effects tend to cancel each other out, hence the impact on the real interest rate will be the net of the effects.
Getting back to our Fisher equation, the nominal interest rate is jointly determined by the inflation rate and real rate of interest. The fact that we are forecasting a lower inflation rate and an increase in the real interest rate means that the decline in the inflation rate will be larger than any increase in the nominal interest rate, i.e., the increase in bond yields.