Author|Dai Xianfeng
Overseas macro hedge fund manager, communication planet APP expert (TA has settled in communication planet APP)
PS: The views in this article are for readers' reference only and do not constitute personal investment advice, and investors should judge and bear their own risks based on their own circumstances.
A. Summary
There are a variety of ways to analyze interest rates. I focus on using the traditional framework to analyze interest rates under normal conditions, and the MMT framework to conceptually explain how interest rates would behave in extreme cases.
The traditional framework breaks down nominal interest rates into natural interest rates, inflation, and risk premium components. Each of these components has its own framework that, taken together, provides a long-term picture of interest rates.
Over time, the natural rate of interest may decline as long-term growth may normalize to lower levels. Inflation is likely to continue to decline as inflation in goods and services is likely to fall. If inflation falls while demand for Treasuries remains strong, the risk premium could fall. As a result, nominal interest rates are likely to decline over time.
Under the Modern Monetary Theory (MMT) framework, inflation is a political decision, and the Fed can set interest rates at any level. Congressional political decisions about fiscal spending affect demand, which in turn affects inflation. The Fed could theoretically set interest rates at any level and could even pay extremely high interest rates to the Social Security Fund to solve its funding problems. This framework distinguishes the financial sector from the real economy. Therefore, since the U.S. dollar is legal tender, the U.S. government, regardless of its size, can always pay its debts. The only constraint is inflation in the real economy.
Under the MMT framework, the accumulation of government debt, regardless of the size of the debt, does not have a direct impact on interest rates. An explosive rise in interest rates, triggered by high debt levels, which is so feared, is not a possibility.
The two frameworks complement each other. The traditional framework deals with interest rate fluctuations under normal circumstances. The MMT framework helps to understand the tail risk of interest rates – there is no tail risk for interest rates.
B. Historical facts about interest rates
Global interest rates have been falling to zero for hundreds of years.
Source: Bank of England
Over the past 60 years, U.S. interest rates have gone through a cycle of rise and a decline. The yield on the US 10-year Treasury bond rose for more than 20 years from the 60s to the early 80s of the 20th century and fell for nearly 40 years from the 80s to 2020. As inflation soared, interest rates began to rise in 2020.
C. Traditional frameworks: R*, inflation, and risk premiums
Within the framework of traditional analysis, there is a high probability that interest rates will fall, because their components may fall.
Under the traditional framework, nominal interest rate = R* + inflation + risk premium. Predicting a future nominal interest rate is equivalent to forecasting its three components.
C1. R* may fall as the growth trend declines
R* follows the trend growth rate. The trend growth rate is likely to normalize to a lower level. As a result, R* is likely to fall.
From 2000 to 2013, the trend growth rate declined, and so did the R* value. From April 2013 to October 2021, the trend growth rate increased, but then declined again. The growth trend could fall back to the "normal" after the 2008 financial crisis
The Fed's forecast for long-term economic growth is 1.8%.
Source: Federal Reserve
Economic growth since 1970 shows a downward trend between 1980 and 2010 but an increase between 2010 and 2020. The epidemic phase is an abnormal period. The growth rate has been declining since 2020.
C2. Inflation is likely to continue to decline
Commodity price inflation is likely to continue to decline, driven by higher global production. The labor market is slowing and service inflation is likely to continue to moderate.
C2.1. Goods inflation is likely to continue to decline.
The decline in goods inflation is due to improving global production. In 2024, the supply chain bottleneck index will decline again, indicating that the global supply chain continues to improve. As a result, commodity price inflation is likely to continue to decline.
Oil price inflation has been at a moderate level and is likely to fall, supporting persistent commodity deflation.
China's sluggish economic recovery is also one of the reasons for the slowdown in inflation in other parts of the world. In 2024, China's economic recovery will improve. But without any large-scale stimulus, China's economic growth is likely to be modest, and its impact on global inflation is likely to be limited.
C2.2. Services inflation is likely to slow.
The drivers of services inflation are benign. The job market (JOLT and wage growth) continues to slow.
C2.3. Interest rates are at restrictive levels
The federal funds rate is currently at a restrictive level. It may take more time to make a difference in the economy, but it is restrictive based on the final interest rate estimate (2.5%), the target inflation rate (2%), and historical comparisons.
Given the current inflation, the federal funds rate also appears to be restrictive.
C3. Risk Premium
If inflation falls, the bond risk premium/term premium may fall. This could further depress nominal interest rates.
Term premiums have historically been associated with inflation. In the 70s and 80s of the 20th century, when inflation soared and became more volatile, term premiums rose rapidly. Since the mid-80s of the 20th century, term premiums have declined as inflation has fallen.
Although implied volatility has declined since April, term premiums remain elevated. Therefore, if the deflationary trend reappears, there is still room for the term premium to fall.
Real volatility has been declining since May. This could pull down term premiums.
Inflation expectations have fallen. This could put downward pressure on term premiums.
D. Interest rates will be under control regardless of the level of debt
The MMT framework separates the financial sector from the real economy. Since the U.S. dollar is legal tender, the U.S. government can pay the principal and interest on U.S. Treasury bonds without restrictions. The Fed can set interest rates at any level. The cooperation between the Treasury Department and the Federal Reserve can ensure that there is no "debt crisis" in the sense of principal or interest payments.
The only constraint is inflation.
D1. The U.S. Treasury can make payments of principal and interest regardless of the level of debt
The U.S. Treasury can repay the debt regardless of the debt level. The debt is denominated in U.S. dollars, and the Federal Reserve (acting as a proxy for the U.S. Treasury) can pay off all outstanding debts with simple accounting entries. The Federal Reserve controls interest rates so that the U.S. Treasury is always able to pay a reasonable level of interest rates.
There is no such thing as "central bank independence" in nature or in extreme cases. The central bank is part of the U.S. government.
Japan is an example of this. Debt levels in the United States have been rising for decades, and interest rates have not affected them. Its interest rate has instead fallen.
D2. The Fed can set interest rates at any level
Mechanically (but not necessarily legally), the Fed can set interest rates at any level. The Fed can even tailor interest rates to specific holders, such as social security trusts.
There is no such thing as "central bank independence" in nature or in extreme cases. The central bank is the fiscal agent of the government.
E. Conclusion
In the long run, interest rates are likely to trend downward, as all three components (natural interest rate, inflation, and risk premium) are trending downward.
In extreme cases, interest rates are highly unlikely to get out of control, regardless of debt levels. First, U.S. government debt may not reach excessively high levels, and if inflation erupts, the U.S. Congress may not approve excessive spending – fiscal deficits are spending, and spending creates inflationary pressures. Since U.S. Treasuries are denominated in the US dollar, the U.S. Treasury can repay its debts without restrictions. The Fed can set interest rates at any level.