Selasa, 17 September 2013

How much higher should interest rates be?

We're leaving paradise today, so in the absence of time I offer this chart which makes a statement about the level of inflation and interest rates over the past decade. Inflation and inflation expectations are one of the most important determinants of interest rates.

From 1993 through early 2011, Treasury yields tracked core inflation quite closely, and interest rates were always somewhat higher than inflation, just as theory would predict. But from early 2011 through April of this year, that wasn't the case: interest rates moved down while inflation rose, and interest rates fell below the level of inflation (and real interest rates entered negative territory).

Most observers seem to believe that interest rates were abnormally low because of the Fed's QE program. But as the chart above shows, interest rates actually rose each time the Fed bought large quantities of bonds.

I've argued that interest rates fell to unusually low levels because the world expected U.S. economic growth to be very weak, and feared that another recession was on the horizon. Interest rates have moved higher of late because the outlook for the U.S. economy has improved somewhat.

The recent jump in rates appears to be the first step in restoring the normal relationship between interest rates and inflation. Rates are still relatively low, however; if inflation remains at current levels and the economic outlook continues to improve (e.g., the market begins to price in growth expectations of 3% or better), then short- and intermediate-term interest rates should and could rise by another 100 bps. 10-yr Treasury yields could rise by another 50 bps or so.

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