U.S. Interest Rates and Inflation Update

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In response to rising inflation, the Federal Reserve raised the effective federal funds interest rate from 0.08% in January 2022 to 3.08% at the end of September 2022. A key question is how much it will increase rates further? A review of interest rates and inflation in the United States since 1962 suggests that the answer depends on whether the current rise in inflation is caused by temporary or more permanent factors. The 10-year Treasury market believes that current inflation is mostly temporary. If this view is correct, history suggests that the Federal Reserve’s rate hikes are nearing an end. But the markets are not always right. While the current higher inflation mainly reflects more permanent factors, further rate hikes are likely in the years to come. The data used in this article comes from Federal Reserve Economic Data (FRED) maintained by the Federal Reserve Bank of St. Louis.

Interest rate: The Federal Reserve has direct control over the federal funds rate. Its impact on other interest rates is indirect and depends on the relationship between the other interest rate and the federal funds rate. The 10-year U.S. Treasury bill rate, a cost-of-borrowing indicator for the federal government, and Moody’s Seasoned Aaa Corporate Bond Index, a cost-of-borrowing indicator for high-quality corporations, follow close to the federal funds rate (see Figure 1). Since 1962, when information on 10-year US Treasury bond rates was first published in FRED; the correlation with the fed funds rate is respectively +0.92 and +0.88 (+1.0 is a perfect correlation). In summary, the impact of the Federal Reserve on these two important US interest rates is considerable.

Over the period 1962-2021, the yields on 10-year Treasury bills and the Moody’s Aaa Corporate index exceeded the federal funds rate by an average of 1.1 and 2.1 percentage points respectively (6.0% and 7.0% versus 4.9%). In September 2022, the differences were 0.9 and 1.5 percentage points, respectively, slightly less than the average historical difference.

Inflation and interest rates: The implicit price deflator index of gross domestic product (GDP) is considered the most comprehensive measure of prices in an economy. The annual average federal funds rate and the inflation rate in the United States, as measured by the 12-month change in the GDP deflator index, track each other (see Figure 2). Their correlation is +0.70.

Over the period 1962-2021, the federal funds rate was on average 1.6 percentage points higher than GDP deflator inflation (4.9% versus 3.3%). However, during the second quarter of 2022 or the latest available GDP deflator data; GDP deflator inflation topped the federal funds rate by 6.8 percentage points (7.6% vs. 0.8%) after topping the federal funds rate by 4.1 percentage points in 2021. Prior to 2021, 3.4 percentage points in 1975 was the maximum that GDP deflator inflation had exceeded the federal funds rate. The differences since 2020 underscore how far inflation has outpaced the fed funds rate.

Actual and expected inflation: FRED publishes a market estimate of average inflation expected over the next 10 years. It is derived from the 10-year Treasury constant maturity bond and the 10-year Treasury inflation-indexed constant maturity bond. It was first published in 2003. Over the period 2003-2021, the 10-year inflation expectation averaged 2.0%, the same as GDP deflator inflation. During the second quarter of 2022, the 10-year expected inflation was 2.7%, less than 1.0 percentage point above its 2003-2021 average. In contrast, GDP deflator inflation was 7.6%. There is a significant gap between current inflation and expected inflation.

Summary observations

Market expectations for 10-year inflation have diverged significantly from current inflation.

The market’s 10-year inflation expectation is not much higher than its average 10-year inflation expectation over the period 2003-2021, implying that the market believes that most of the Current inflation is temporary.

If we assume that the market inflation expectation is correct, add the average difference of 1.6% between the federal funds rate and the GDP deflator inflation over the period 1962-2021 (the deflator inflation of GDP is available more years than market expected inflation) at 2.4% market expected 10-year inflation in September 2022 implies a federal funds rate of 4.0%. The federal funds rate at the end of September was 3.1%, suggesting that interest rate hikes by the Federal Reserve are nearing an end.

Using historical relationships since 1962, a federal funds rate of 4.0% implies a 10-year US Treasury bill rate of 5.1% and a Moody’s Aaa Corporate Index rate of 6.1%.

Assuming that expected market inflation is accurate, the Federal Reserve’s interest rate hike in 2022 can be seen as restoring the relationship between interest rates and inflation that has existed for much part of 21st Century.

Economics generally accepts that markets are a good, perhaps the best, tool for economic forecasting, but markets are not perfect forecasters. To illustrate the implication of this point, assume that the 10-year inflation rate is 5%. This rate is close to the average of the last GDP deflator (7.6%) and the 10-year inflation expected by the market (2.4%). This also means that about half of the current rise in inflation relative to the average 21st Century inflation reflects more permanent factors.

Adding the 1.6% average difference between the federal funds rate and GDP deflator inflation implies a federal funds rate of 6.6%, more than double the current rate of 3.1% federal funds. In other words, the Federal Reserve would currently only be halfway through its campaign to control inflation. Using historical relationships since 1962, a federal funds rate of 6.6% implies a 10-year US Treasury rate of 7.7% and a Moody’s Aaa Corporate Index rate of 8.7%.

The large gap between current inflation and inflation expected in the market is a warning signal. Since markets are not always accurate forecasters and economic behavior and debt levels tend to adjust slowly, prudent financial management suggests that it is wise to create contingency plans if current interest rates are low, not high.

The warning flag applies to farms. Assuming nothing else changes initially, higher interest rates mean lower farm income (daily farmdocMarch 21, 2022) and falling farmland prices (daily farmdocMarch 23, 2022), especially since farm debt more than doubled in the post-1990 period of falling and largely low interest rates.

References

Federal Reserve Bank of St. Louis. 2022, October 1. Economic data from the Federal Reserve (FRED). https://fred.stlouisfed.org

Zulauf, C., G. Schnitkey, K. Swanson, and N. Paulson. “Land Price/Rent Ratio and Interest Rates.” daily farmdoc (12):38, Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign, 23 Mar 2022.

Zulauf, C., B. Zwilling, G. Schnitkey, N. Paulson, and K. Swanson. “Role of US Farm Interest Expenditure in Agricultural Production Expenditure.” daily farmdoc (12):36, Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign, 21 Mar 2022.

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