The debate over the FED’s expansion on their asset purchase programme is over. Long-term interest rates will continue to increase, making the Powell´s administration's only exit to enlarge it.
Less than a week ago, 10-year bond yields surged to a new post-COVID high, the NASDAQ plunged around 3% and closing on the low. In contrast, the Dow Jones, was not affected as much, the main reason for that being the fact that markets are staying away from rising-orientated stocks, focusing instead in value dividend (defensive) stocks.
The volatility of both the NASDAQ and the Dow Jones with direct ties to movements on bond yields, will certainly force the U.S Central Bank in charge of Jerome Powell into a countermeasure. This measure will be materialized by infiltrating into the bond market and purchasing all the despised treasuries. To understand this, it is important to undertake the assumption that the Federal Reserve is taking fiscal precautions in the face of increasing interest rates. The problem being that markets not only not trust Powell when he declares they will keep interest rates at 0%, but they also can’t figure out how will the board maintain this position in the long run. Powell´s administration will undoubtedly need to uplift interest rates in-time.
The Board of Governors is now foreseeing, as they strengthened their 2021 projections for both GDP growth and inflation, an increase expectation of 6.5%, with inflation moving up to 2.4%, in addition to unemployment back-pedalling into 4.5%. What Powell is dictating, considering this GDP growth, unemployment, and inflation projection, is that they will maintain the FED´s Fund Rate at 0%.
Looking over both the Board´s projection and the 0% interest rates, it is obvious that something is not making sense, and it might be interest rates. What is Powell´s justification for the mixture of 0% interest rates and Quantitative Easing (QE), while having 6.5% GDP growth, 4.5% unemployment, and well above from the 2% target inflation at 2.4%? It simply doesn’t add up, and it does not make any sense to markets either. They take for granted that interest rates will inevitably increase, despite Jerome Powell´s greatest efforts to deny it.
We have to go back to 1984 when the U.S economy last saw an annual GDP growth of 6.5% or higher, as a matter of fact, going back to the end of WW2, in only four different years the GDP growth was higher than 6.5%. To simple this up, this year (2021), will be one of the seven best years in terms of GDP growth for U.S since WW2.
Just after the great recession of 1980-81, during the Reagan administration, coming up with a 7.4% bounce back on GDP growth in 1984, inflation was at 3.9%, surpassing the central bank´s 2.4% estimate, unemployment was at 7.3%, substantially above the 4.5% projected unemployment from Powell. The key matter here is to know the interest rate for the fiscal year of 1984, and the answer is that it ended the year at a discount rate of 8.25% low.
In 1966, during Lyndon Johnson years, the U.S GDP growth was the same estimated by the Board of Governors for this year, 6.5%. The inflation rate was at 3.5%, greatly higher to what Powell´s administration is foreseeing for 2021, in contrast, the unemployment rate was 3.6%, much less than the central bank´s 4.5% prediction. The key question again is, what was the interest rate for the fiscal year of 1966? The answer is 5.25%, with a comparatively lower unemployment rate along with an inflation of 3.5%. The Board of Governors on Bill Martin´s hands was doing what is expected with the given rates by rising them from 4.5% to 5.25%, backed up by strong economic growth (6.5%). Nowadays, having the same growth forecast as in 1966, the FED is not raising rates anywise, on the contrary leaving them at 0%.
What is clear is the fact that interest rates were significantly higher in both 1966 and 1984, compared to the 0% in 2021. Jerome Powell insists on maintaining rates, and it is optimistic enough to project a strong economic rebound with incredibly low unemployment, unfortunately for him, markets have started to realize how defenceless the Powell´s Administration is against inflation, and that it lacks both the tools and the will to counter it.
Written by Nicolas Martinez
Nicolas Martinez is a columnist at DecipherGrey.