The terms “normal,” “normalize,” and “neutral” are common in today’s economic discussions. But, does anybody really know what “normal” is? When the Federal Reserve (Fed) says that it wants to “normalize” interest rates, do they have a rate scheme in mind? Does it mean that rates will be similar to what they were 10-20 years ago? That’s what most people believe “normal” is. The truth is “normal” is significantly lower.
The current Fed Funds rate is 2.25%-2.50%, and it appears that this will be the peak for this cycle. The peak last cycle was 5.25%, and it was 6.50% the cycle before. One must retreat all the way back to the 1940s, when rates were “administered” after WWII to find interest rate peaks at such low levels.
Rapidly Changing Economy
It does appear that the economy has rapidly changed over the past decade. Think about the changes that have occurred in the past decade that we can easily identify:
- The way social media has changed behavior;
- The growth of online sales, and the struggles of traditional retailers;
- The changes in attitudes that led to upstarts like Uber, Lyft, and Airbnb;
- The near-complete dependence on the hand-held device and the time spent on it daily.
And, think about the changes that are coming; autonomous vehicles, changes in banking and the payments system, and things that I can’t yet conceive of.
The Elusive “Normal”
“What are the ‘normal’ interest rates that we are trying to ‘return to?’” is a legitimate question. It just doesn’t appear to be what we had 10, 20, 30, or 40 years ago. It looks to me to be a lot lower!
As late as October, the Fed was convinced that interest rates had to be pushed higher. Chairman Powell’s remark that the Fed was moving rates toward “neutral” but still had a long way to go to get there started the equity market on its downward spiral. Then, in December, the Fed raised rates with a “hawkish” sounding statement and press conference, promising at least two more rate hikes in 2019. After the Christmas market tantrum, the Fed walked it all back, became dovish sounding, and some current members and the former Chair, Janet Yellen, indicated that the next rate move would be a cut. Yet, as late as Thursday, February 7th, Powell once again sounded like the Fed was just in a holding pattern, waiting for more data (His remark: “The U.S. economy is now in a good place.”).
Clearly there is a struggle at the Fed as to where the elusive “neutral” might be. For sure, it isn’t where it was in the 80s, 90s, or 00s. For example, today 20% of global debt carries a negative interest rate (and we are at the top of the cycle). Whoever heard of that in decades past or would have reason to believe it to be “normal?” Yet, these negative interest rates have been around for several years.
Since the Recession, global debt has exploded. Demographic structures have changed and productivity growth has been elusive despite the great strides in technology. Japan’s economic struggles with its ageing population are well documented. Perhaps the world is now in sync with Japan’s recent experience. There, the 10 year government note yield is 0%!
The Changing Economy
It is likely true that the economy’s reaction to economic stimulus has been changing throughout the post-WWII era. That’s probably why the Fed hasn’t ever been able to figure out the length of the lags between monetary policy changes and economy’s reaction or the exact transmission mechanisms. Add to that the fact that economic change has been much more rapid in the past 10 years and one might understand why the Fed seems so confused. It, then, isn’t any wonder that the Fed has rarely recognized an oncoming recession/slowdown in a timely manner. And, given the fact that, today, the Fed has yet to ease policy (has only talked about it) and that their balance sheet is still shrinking (i.e., they have talked about the future of Quantitative tightening (QT), but haven’t yet taken steps to change its trajectory), if the developing economic slowdown is as serious as it appears to be, then they may yet again be late in shifting policy.
Today, the world’s economies once again appear to be “synchronized,” but this time in deceleration/contraction. China leads the way with decelerating growth, now at levels not seen for three decades. With official sounding European agencies all radically reducing 2019 growth rates, the eurozone appears ready to plunge into recession. Japan, too! While the U.S. economy’s data still shows up at decent levels, trends are downward and the magnitude of those down spikes is concerning.
U.S. equity markets have retraced 60% of December’s give-back, but now appear to be stalling. Yields on longer-term Treasury debt are also on a downward path. If economic prospects were strong, those yields would be rising. And, as pointed out above, long-term rates elsewhere are negative. Bond markets, worldwide, continue to send signals of renewed deflationary pressures.
The search for “normal” continues. What is clear is that “normal” levels of interest rates are much lower than in decades past, as is the “neutral” Fed Funds rate. The Fed’s recent behavior confirms that they remain in the dark. In the post-WWII era, that very Fed actually engineered three soft-landings (mid-60s, mid-80s, and mid-90s). But, for the most part (10 other times), their over-tightening led directly to recession. In those soft-landing episodes, the Fed cut rates aggressively. Today’s Fed has moved away from tightening, but they have yet to ease. Talking the talk is one thing, walking the walk is another.
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Four Star Wealth Advisors, LLC, www.fourstarwealth.com (775 284-7778).
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert is co-portfolio manager of the Fieldstone Financial Unconstrained Medium-Term Fixed Income ETF (FFIU).
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.