The Federal Reserve is on track to raise interest rates later this year. Chairwoman Yellen has good reasons to push ahead, but she may not get very far in her quest to “normalize†rates.
Inflation is heating up.
Thanks to falling oil prices through January, consumer prices are down 0.2 percent from a year ago but more recently oil and retail gasoline prices have been surging. Core inflation, which excludes volatile energy and food prices, is quite close to the Fed’s target of 2 percent and accelerating in recent months.
Investors are building a 2 percent inflation premium into the price of 10 and 20 year Treasury securities, and history teaches inflation can fly out of control if the Fed does not act preemptively.
Image Source
Rock bottom short term interest rates impose significant distortions on labor and asset markets. For example, elderly Americans rely on CDs to invest significant portions of retirement savings but the 5 year rate on those is 1.45 percent—well below expected inflation, especially factoring in taxes. Consequently, larger numbers of Americans over 65 are working, crowding out young job seekers struggling to start careers.
Near zero short term borrowing rates for banks artificially lower risks on trading, deal making and financing hedge funds and private equity plays, and distract banks from lending to young businesses with good ideas to grow the economy.
Cheap mortgages have pushed up residential real estate values to levels that discourage homeownership by young families. That’s an important reason new home construction has not recovered to pre-financial crisis levels.
The Fed has indicated it would like to slowly raise the overnight bank borrowing rate (federal funds rate) from 0.125 percent to 3.75 percent. By my estimates, that would imply a nominal 10-year Treasury rate of 4 to 5 percent—or adjusted for inflation a real interest rate on productive business investments of 2 to 3 percent. That is simply not sustainable now or in the foreseeable future.
