This post originally appeared last spring and is part 2 of a series on what happens when interest rates start to rise.
In part 1 of this series, I explored what interest rates would look like if they returned to their natural level and determined they would be approximately 5 percent on a nominal basis (assuming 2-percent inflation). As the Federal Reserve (Fed) has determined that 2 percent is the target inflation rate, this approximation of the natural rate seems reasonable. Current interest rates, however, are well below 3 percent, resulting in an obvious gap between where the rate is now and where it should be.
So, what’s keeping the rate gap open, when will it close (we may take a step closer this afternoon), and what happens then? (For those who read yesterday’s post, these are questions 2, 3, and 4.)
Looking to the Fed for answers
You’d think these would be simple questions to answer. After all, the Fed spent trillions of dollars buying securities specifically to keep rates down. Surely it has a detailed explanation for how that works, the extent of the effects, and what happens when it pulls back. Right?
Wrong. A commentary from the Cleveland Fed breaks out the components that make up interest rates. Explanations for low rates include:
• Low expected inflation
• A decline in the real interest rate to just about zero
• The higher rate that is required for longer time periods, known as the time premium
Absent is any discussion of the effects of quantitative easing.
A discussion of quantitative easing (QE) from the St. Louis Fed defines and defends it, concluding that the Fed’s program reduced rates by about 75 basis points, or 0.75 percent, through a lower-term premium. For our purposes, we can ignore the details and surmise that, without the Fed’s stimulus, rates would be that much higher: 2.28 percent plus 0.75 percent, for a rate on the 10-year Treasury of 3.03 percent. This is still below the 5 percent we would expect.