12/09/2021
INTEREST RATES
Five Key Questions for U.S. Treasury Yields
Supply chain disruptions and the relative demand shift away from services and into goods both combined to lift inflation above 6% in 2021.
The shape of the yield curve is likely to shift depending on the relative mix of expectations about the Fed pushing short-rate higher, whether future inflation will decline quickly or not, and how well equity markets absorb the changes in Fed policy.
U.S. Treasury 10-year yields over the course of history have tended to embed a risk premium for future inflation. That risk premium was erased by quantitative easing and low rates in the 2010-2021 period. Will it reemerge once QE has ended and short-term rates are rising?
When one is uncertain about the future course of inflation and the economy is doing quite well, one policy choice might be to adopt a neutral short-term interest rate policy. Our analysis suggests the Fed might consider a neutral policy to be one in which the target range for the federal funds rate was more or less on top of the Fed’s 2% long-term inflation target.
The Fed has guided that it wants to end QE before considering raising short-term rates. Technically, however, it is possible for Fed to raise rates and continue with asset purchases, even if that is not likely. That is, lift-off for higher rates does not technically depend on Fed asset purchases ending.
U.S. Treasury yields are on the move. Inflation is elevated. Labor markets are doing very well and unemployment is declining. Real GDP has surpassed the pre-pandemic peak. The Federal Reserve (Fed) is withdrawing from its asset purchase program (aka QE) and may end net asset purchases in the first half of 2022. After QE has been terminated, then the Fed will consider raising its target range for the federal funds rate. All the while, Covid-19 complicates the picture with new variants. In this essay we examine five questions that are key to how yields on U.S. Treasuries may move in 2022, and how the shape of the yield curve may change.
1) Inflation: Driven by Supply or Demand?
Was the 6%-plus elevated inflation rate observed in 2021 supply or demand driven? Both. Every product or service that changes hands has a seller (supply) and a buyer (demand), so the analysis of why prices move always involves both supply and demand. In the case of the pandemic, supply and demand were impacted in very unusual and atypical ways.
The two major changes on the demand side were, 1) the direct payments to individuals by the U.S. federal government to cushion the blow from the partial shutdown of the service sector, and 2) the shift in consumption patterns away from services and toward goods.
First, the direct payments to individuals allowed a much more rapid recovery of personal consumption back to pre-pandemic levels than otherwise would have been possible, and by end-2021, real GDP was about 3.5% above the pre-pandemic peak in Q4/2019. The 3.5% growth over two years was an amazingly rapid recovery from the pandemic shock, yet was well below average demand growth for a two-year period. So, we do not give much general demand-side credit to fiscal policy in terms of influencing the elevated rate of inflation observed in 2021 even if it helped create a more rapid recovery from the shock. Second, the relative shift away from spending on services to goods was a major upward demand shock for goods that exacerbated supply-chain challenges and impacted goods inflation in 2021. That is, the demand influence that was important for inflation came from a relative shift in demand from services to goods and not an overall, persistent increase in general demand.
On the supply side, there were myriad challenges. In some cases, ports were impacted by COVID-19, which disrupted the loading and unloading of containers. Container production slowed in the spring of 2020, and then took time to ramp back up to meet the rising exports of goods coming from China to the U.S. and Europe, due to the relative shift to consumption of manufactured goods. The shift to goods also resulted in computer chips being in short supply, leading to a slowing of automobile production, and pushing the prices of used cars to all-time highs. These were just a few of the many supply chain disruptions induced by the pandemic.
