Could we see another summer bump in interest rates?
Here is a simple version of a Taylor Rule rate, which is now at 2%. I realize that the Taylor Rule is not necessarily applicable in the current climate. And, I would even argue that the Taylor Rule overestimated the natural rate by about 2% in the 2000's and could be overestimating the natural rate by up to 3% to 4% now. This would have to be the case for the current yield curve to be reasonable, because the Taylor Rule rate would be somewhere near 4% by the time the market expects the Fed to raise rates. I'm not sure that that is the case. One sign regarding this issue will be how inflation behaves over the next year. Seasonally adjusted, month-over-month inflation, while noisy, is showing an increase.
Weekly updates on loans and leases in bank credit also remain strong. The three charts below all have a $500 billion scale over 4 years to show the relative performance of Commercial & Industrial Loans, Real Estate Loans, and Consumer Loans. Real estate is, by far, the largest absolute pool of bank credit, so the capacity for real estate loans to add to credit growth is substantial. So far this year, consumer and industrial credit has been growing at an annualized rate of more than 5%, which is about the lowest level of growth we would expect to see in a sustained recovery period, and that has mostly been due to growth in Commercial and Industrial Loans of more than 10%. The real estate credit market will be an area to watch. I expect to see a sharp recovery.
These factors kind of multiply on themselves. If home prices continue to rise, household net worth will improve, fewer homeowners will be underwater, and the rise in price itself will feed more housing demand. Mortgage costs are very low compared to rent, so this should be a multiplicative mechanism for some time. Similarly, rising inflation might signal that monetary policy has become loose at the current levels of interest rates and excess reserves. This will be a signal that both (1) the Fed will raise rates earlier than we expected, and (2) the natural rate is closer to the Taylor Rule rate than we thought it was, suggesting that rates will need to rise faster and farther than we thought.
On a month-over-month basis, inflation has now shown 2%+ level growth for two months. The May readings will be very interesting.
We could very easily be sitting here in September 2014 with inflation at 2.25% unemployment at 5.8%, and bank credit growing at 10% per year. That would trigger a sharp change in attitudes toward interest rates. I think that is the position to have exposure to right now.
Corporate spreads have recently fallen to ranges that typically coincide with rising rates. Here is a graph comparing various spreads with the level they were at in June 2004 when the Fed Funds rate began to rise. And another graph focused on more recent movements. I think we should take these as a signal of the state of credit markets. Continued spread compression along with expanding credit would suggest strong supply and demand in credit markets.
PS. Don't misunderstand me. I am not arguing that the Fed is too loose and needs to tighten. I am saying that we have been in a context where monetary policy has been too tight, even with rates were near zero and the Fed expanding its balance sheet. But, if this economy continues to recover, there could be a bit of a tipping point where increasing inflation and expanding bank balance sheets mean that the Fed would need to follow rates up in order to prevent inflationary developments. I would still want the Fed to be fairly accommodative, but the interest rate is a moving target, and the time for a 2% interest rate target that is somewhat accommodative may come sooner than it now seems like it might. We should hope for this outcome.