Areté Market Review Q223: The Interest Rate Parlor Game
The second quarter was characterized by a debt ceiling showdown (which perversely provided a boost to liquidity) and by a big spurt in tech stocks. There were plenty of other things going on under the surface, but those were the big headline stories.
The outlook for the rest of the year depends heavily on one's view of monetary policy. One view is that over-tightening has already happened and the economy is on the cusp of a deep recession. Another view has it that the economy is fairly resilient and inflation remains a significant threat. How does one gain an advantage in this interest rate parlor game?
Monetary policy rules
One thing that often gets lost in this debate is that both outlooks depend on the assumption that the primary driver of economic growth is monetary policy. The trouble is that assumption has become increasingly tenuous.
While monetary policy has always had an important role in shaping the economy, it helps to remember its status got significantly elevated in the throes of the GFC. At the time, disorderly deleveraging and sharply partisan political divisions made any kind of cohesive public policy measures coming from Congress virtually impossible. Chuck Schumer perfectly captured the dearth of options for all to hear when he called the Fed "the only game in town". Thus heralded an era dominated by monetary policy.
And so it was right up until the pandemic ... when things changed. The Fed responded to the pandemic quickly by pumping massive amounts of liquidity into the system, but government policy also got dialed up in a way that had not happened in a long time. Through various measures to mitigate the harm caused by the pandemic, politicians rediscovered the ability to exert a massive degree of control over the economy. Lo and behold, they liked it!
Re-emergence of government policy
As a result, government policy stealthily took on a much bigger role in economic affairs. None of this is to say monetary policy lost its influence, or even that its objectives were very different in many cases. In fact, the significant overlap in policy goals has obscured the transition in many ways and caused a great deal of confusion in regard to policy direction. As I mentioned in the outlook for the first quarter, “it is best to think of the Fed’s job as that of doing monetary policy while also serving other political goals”.
What this means is determining the direction of monetary policy has become even harder. Now, in addition to traditional financial and economic inputs, and psychoanalysis of the Fed chair, government policy objectives must also be considered in order to determine the output. On this point, a great place to start is with the speech National Security Advisor Jake Sullivan gave at the Brookings Institution at the end of April.
In that speech, Sullivan listed “four fundamental challenges”. They included:
- “America’s industrial base [that has] been hollowed out.”
- “a new environment defined by geopolitical and security competition, with important economic impacts”
- “an accelerating climate crisis and the urgent need for a just and efficient energy transition”
- “the challenge of inequality and its damage to democracy”
The first thing that stands out is the "new environment" is defined by "geopolitical and security competition". This explicitly states the environment has changed and that geopolitics and national security are now top priorities. This is a lot edgier and more purposive than vague monetary policy statements about abstract targets.
Another thing that stands out are the fairly specific areas of focus. Challenges such as a "hollowed out" industrial base and widespread "inequality" have very clear implications for policy. They are also fairly clear admonishments to zero interest rate policy (ZIRP).
Yet another "challenge", which is unstated, is that of reducing debt relative to economic production. In an important sense, this is a national security concern. It is also a political concern. Either way, no elected official wants to mess with the risk of its country losing control of its currency. Because it is a fairly abstract issue, however, it also not the kind of issue politicians want to be in the spotlight (and therefore subject to the court of public opinion).
So, what kinds of implications might these government policy objectives have for monetary policy? In other words, what types of monetary policies would be consistent with, and therefore complementary to, achieving the goals of Sullivan’s policy platform?
With excessive debt and excessive financialization being important concerns, a good place to start would be to sustainably raise short-term interest rates. Higher rates would slow the growth in debt by making it more expensive. After all, the first thing to do when you're in a hole is to stop digging.
Higher short-term rates would also accomplish other goals as well. For example, higher rates would incentivize investment in productive capacity whereas zero rates incentivize financial engineering. In addition, higher short-term rates constrain unregulated credit creation by undermining the economics of asset-backed lending. This keeps more lending under the regulatory umbrella and therefore (ostensibly) reduces risk to the financial system.
Higher short-term rates help lay the groundwork for Sullivan's policy goals, but also cause other problems when long-term rates fail to rise commensurately. Namely, when short rates are higher than long rates (i.e., an inverted yield curve), it is hard for banks to make money by lending.
As a result, it is important at some stage to allow long-term rates to rise above short-term rates.
This allows banks to operate more profitably and therefore to rebuild capital. The end result is a banking system that is sounder, more stable, and more capable of lending for the purpose of rebuilding industrial production.
Operationally, long-term rates can be lifted a couple of ways. The Treasury can take the lead by allocating relatively greater proportions of its overall funding to longer-term bonds. As supply overtakes demand, prices will decline and yields will rise. The Fed can also get involved by increasing Quantitative Tightening (QT) or by selling down its mortgage-backed security (MBS) portfolio (or both).
The final policy step involves financial repression. With an ultimate goal of public policy being to reduce the debt burden, the least worst way to do so is by maintaining long-term interest rates somewhat below inflation. As a result, inflation slowly, but persistently, erodes the value of that debt.
Provided that inflation remains at least moderately positive, the mechanics of doing so are straightforward. It’s just another form of yield curve control whereby the Fed consistently purchases enough long-term debt to keep long-term interest rates modestly below inflation.
One thing to note about these “planks” is they require a fair amount of intervention to implement. Another thing to note is they each have negative side effects. As a result, there needs to be a good case for implementing them, one that produces benefits that are clearly greater than the costs.
In regard to the first plank, the best possible case to raise short-term interest rates is to fight inflation, and that is what the Fed has done. It is interesting to note that the Fed’s disposition toward inflation changed materially after Russia invaded Ukraine. In other words, once the inflation problem also became entangled with national security concerns, the demeanor of the Fed changed.
The implementation of the second and third plank largely fall out from the first. If long-term rates do not follow in step from higher short-term rates, the inverted yield curve will put pressure on bank profitability. The mini banking crisis in the first quarter made it clear that the banking system could be stronger – which would happen if longer-term rates rose above short-term rates.
Finally, if long-term rates are high enough for long enough, investors will happily move out of equities and into bonds. That will provide the necessary groundwork to begin financial repression.
So, how does the theory of monetary policy serving other political goals hold up? Let’s take the current challenge of handicapping whether the Fed continues raising rates in the context of rapidly falling inflation numbers.
Judging by economic criteria alone, one would suspect the tendency would be greater to lower rates than to raise them. Considered in the context of a policy objective of creating a fertile environment for rebuilding industrial capacity, however, odds tilt more towards raising short-term rates.
Interestingly, former New York Federal Reserve President Bill Dudley corroborated these rate implications in recent comments. Specifically, he noted, "the Federal Reserve will probably be taking short-term interest rates higher for longer".
He also addressed the direction of longer-term rates. Specifically, he said: “Since last fall, the 10-year Treasury yield has remained in a narrow range near its current level of 3.75%. There’s little reason for it to stay there, and many reasons to expect it to move considerably higher.”
In both cases he justifies his position in economic and financial terms. In both cases, the justifications have merit, but are also at least somewhat subjective. In both cases, incorporating government policy goals as an input helps to support the economic and financial evidence, and therefore to clarify the direction of monetary policy.
One way to think about Sullivan’s policy goals is to consider them as a fairly comprehensive effort to reshape the economy. Industrial production will be in and financialization will be out. Regulated financial institutions like banks will be in and unregulated lenders will be out. In a very general sense, it favors the Main Street economy over the financial economy.
This has significant implications for financial assets. It means a quick return to a persistently low-rate environment is unlikely. It is not in the playbook. It also means having a lot of debt without the cash flows to cover it, or the cash flows to be able to refinance at new, higher rates, will be a big problem. Finally, it suggests very serious headwinds for financial assets in general.
On the other hand, more normal interest rates will also create a friendly environment for industry to re-establish itself. It will take time, but the opportunity is enormous.
Investors who have become acclimated to the overarching importance of monetary policy would do well to also consider the growing influence of government policy. Regardless of what one thinks about Sullivan’s policy framework, government policy has an authority that monetary policy does not - because it comes from elected officials.
Further, it’s helpful to remember the goal is not so much to win the parlor game of guessing specific monetary policy decisions. Rather, the goal is to understand the policy environment for the purpose of better managing portfolio construction. Since the goals of government policy differ materially from the goals of most post-GFC monetary policy, it’s fair to expect the investment environment will be much different as well.
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