I am scheduled to discuss policy-driven interest rates and other market forces on Bloomberg TV at 8 AM on Tuesday morning. In the meantime, here’s a rundown of the picture as we at Cumberland Advisors see it now.
If the rate of inflation is 2% and the cost of funds is 1%, then the “real” interest rate is negative. That means a borrower is receiving a 1% subsidy from the lender in inflation-adjusted terms. Things change depending on who is the borrower and who is the lender. Things also change depending on the interest rate calculation used. And things change again depending on which measure of inflation is used and depending on whether that measure of inflation reflects the actual experience of the borrower and, separately, of the lender.
We will cite the Federal Reserve Bank of Cleveland and the monthly memo sent our way by Joel Elvery, joel.elvery@clev.frb.org, with the calculations of various measures of inflation. Joel’s email is excerpted below. The Cleveland Fed is a source of pioneering work about inflation measures. The monthly release is available free to anyone who is interested.
“According to the Federal Reserve Bank of Cleveland, the median Consumer Price Index rose 0.2% (1.8% annualized rate) in March. The 16% trimmed-mean Consumer Price Index was unchanged (0.3% annualized rate) during the month. The median CPI and 16% trimmed-mean CPI are measures of core inflation calculated by the Federal Reserve Bank of Cleveland based on data released in the Bureau of Labor Statistics’ (BLS) monthly CPI report. Earlier, the BLS reported that the seasonally adjusted CPI for all urban consumers fell 0.3% (-3.4% annualized rate) in March. The CPI less food and energy fell 0.1% (-1.5% annualized rate) on a seasonally adjusted basis. Over the past 12 months, the median CPI rose 2.5%, the trimmed-mean CPI rose 2.1%, the CPI rose 2.4%, and the CPI less food and energy rose 2.0%.”
So we have about a 2% inflation rate in consumer prices, roughly in line with the Fed’s target, although the Fed looks at other inflation measures, too.
Action Economics (https://www.actioneconomics.com) is a firm I have known for years and use regularly. Mike Englund and his colleagues have delivered detailed analysis since 2004. Their release dissects the CPI in detail and also recaps details on inflation measures like the PCE and core PCE. Those measures are believed to be the focus of the Fed’s deliberations, though most Fed folks I talk with say they really look at all the inflation measures.
Looking at the various measures of inflation in addition to the those related to the CPI, we see an underlying trend of about 1.5%, and it is rising or seems to be rising. Let’s accept that as the present measure. So we have wholesale or core inflation measures at about 1.5% and rising, and retail or consumer inflation at about 2% and rising. What do these numbers mean?
They simply mean that the Federal Reserve has enough data to continue on its path of gradually normalizing policy and restoring the central banking system to something other than the massive quantitative-easing-driven policy that evolved at the end of 2008 and in early 2009. The Fed can act and proceed on the basis that most of the damage done by the financial crisis is behind us. Not all, mind you, but most.
The problem at the Fed is really about WHO is going to make the policy and WHAT policy will be handed off to the new Fed. Here is where looking ahead gets difficult for market agents like Cumberland and our clients.
It is expected that President Donald Trump will name five or, maybe, six of the seven governors of the Fed within the next year. He will name the chair and vice-chair and the regulation czar and fill two existing vacancies. And his nominees are very likely to be confirmed.
So under this assumption, members of the present Fed leadership face a formidable task. They want to persist in fostering gradual recovery. They want to maintain a liquid and functioning financial system. They want to be predictable and thus not shock markets. And they are patriotic members of the US government, so they realize that they must respond to any serious geopolitical threat that impacts the country and the financial system. And the present leadership has only months left to complete this task before they are replaced. And they have to develop the remainder of this year during a period when the federal budget resolution is unresolved and when a possible government shutdown looms. That means the Treasury operations are impacting the financial markets every day as the Treasury must prepare for the worst while hoping for a political outcome that is stable.
We have lots of questions about WHO will make up the next Fed. And without answers we cannot be sure of the WHAT. But we do have some reasonable guesses about policy over the next few months or as much as a year.
We expect the Fed to hike rates twice more in 2017. The December 31st year-end target rate will be a half point higher than it is today. That would put the IOER rate at 1.5%. The repo rate would be about 1.20%, and fed funds would be somewhere in the middle. LIBOR-based rates would be above those rates, and three-month LIBOR could be close to 1.8% to 2%. For reasons we will discuss in a future piece, we think the bias is to the higher end of LIBOR estimates.
All this is a best guess as of today and could change, of course, with incoming data or external events.
Our present investment structure at Cumberland starts with these estimates of short-term policy-driven interest rates. We also believe that intermediate and longer term rates will have more volatility in the future and the range of those rates will be wider than in the last few years. That is why we favor spread product and not treasury notes and bonds. We want to earn the higher coupon in times like the present.
Please tune in for further discussion on Bloomberg TV at 8 AM on Tuesday.