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Interest Rate Theory vs Interest Rate Practice
Even In Economics, Practice Beats Theory Every Time
When the European Central Bank surprised financial markets everywhere with an unexpected 50bps interest rate hike on March 16, instead of the widely anticipated 25bps, I speculated that the ECB was boxing in the Federal Reserve on interest rates, forcing the Fed to raise just to defend the dollar.
With the ECB for the moment sounding more hawkish than the Fed on interest rates and combatting inflation, this latest rate hike, and the relative boost it gives the euro against the dollar, adds pressure on the Fed to keep hiking rates if only to protect the dollar. If the strongest currency is truly the one that comes in last in the global economic race to the bottom, the Fed’s decision on rates next week just became that much more complicated.
Did the ECB push the Fed towards staying the course and raising the federal funds rate 25bps? Quite possibly. Certainly there is data to suggest that is what happened.
The 10-Year Treasury yield actually rose on the heels of the ECB rate hike.
The 2-Year Treasury did likewise.
The ECB rate hike may have exerted pressure on the dollar, but on the interest rate front the rate hike coincided with an uptick in yields for both the 10-Year and 2-Year Treasury.
They joined European sovereign debt yields in moving upward after the ECB action.
If the objective for the Federal Reserve was higher interest rates, the ECB arguably helped the Fed achieve some of its objective.
Perversely and ironically, the Fed itself, by the same logic, may have actually moved bond markets away from its objective, as after the Fed announced its own rate hike yesterday, all of these same bond issuances saw their yields decline—the exact opposite of what the Federal Reserve ostensibly sought.
The Federal Reserve apparently trumped the ECB, but bond markets trumped them both.
Certainly the Fed’s rate hike has been of uncertain impact on forex markets. For both the euro and the pound sterling, the Fed’s rate hike announcement gave the dollar an initial boost, after which the dollar declined throughout the evening, before rising again throughout today.
Nor are the effects of central bank actions confined to bond and forex markets. both the 30-year and 15-year mortgage rates in the US followed similar tracks to the bond markets—rising somewhat on the ECB rate hike on March 16 before declining again after the Fed rate hike on Wednesday.
We should also take note amid this flurry of global interest rate declines that the Bank of England yesterday also raised its bank rate by 25bps.
The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment. At its meeting ending on 22 March 2023, the MPC voted by a majority of 7–2 to increase Bank Rate by 0.25 percentage points, to 4.25%. Two members preferred to maintain Bank Rate at 4%.
Global growth is expected to be stronger than projected in the February Monetary Policy Report, and core consumer price inflation in advanced economies has remained elevated. Wholesale gas futures and oil prices have fallen materially.
Yields on British gilts still declined after the announcement.
Three central banks implemented rate rises within the span of a week and the net effect of all three has been a decline in interest rates in Europe, in the UK, and in the US.
Yet the media still talk of central banks raising rates? Which benchmark market rates are being pushed up by the central bank actions, besides none?
While economic orthodoxy has long held that the key to fighting inflation is for central banks to push interest rates up to shrink the money supply, reduce credit and loan origination, and thus bring prices back down in line with long-term expectations, the data is showing once again the limitations of central bank influence on market interest rates.
Central banks raise their reference rates and pray the markets follow along. Sometimes the markets decline to do so, as has been the case this week.
Nor is this behavior unique to the present circumstance. If we examine interest rates during Fed Chairman Paul Volcker’s battle against inflation during the early 1980s, we see similar limitations on the influence of the federal funds rate.
Multiple times Volker pushed the federal funds rate up only to see Treasury yields decline, and at no time did Treasury yields ever get close to the peaks established by the federal funds rate.
All of which begs the question of how exactly are central bank rate hikes confronting persistently high inflation, be it here in the US or in the UK or in Europe? If higher interest rates are necessary to bring inflation under control, how is it that the central bank rate hikes are failing to produce the necessary interest rate rises within capital markets?
As I observed to one of my readers in a comment on an earlier thread posting about the Fed’s rate hike:
The problem is that the interest rate hikes aren't fighting inflation because the interest rate hikes aren't even happening.
Powell raised the Federal Funds rate in November and December of last year, and Treasury yields DROPPED. They rose briefly after the February 1 hike only to crater over the past two weeks, while the market reaction to yesterday's federal funds hike was to push yields down even further.
How can we have interest rate increases when Treasury yields are lower now than at any time since last September?
The same question may be fairly posed towards the Bank of England and the European Central Bank. If central banks are raising rates….where are the raised rates?
The data is showing central bank influence over market interest rates to be considerably weaker than the prevailing narrative implies. Yet if the central bank influence over interest rates is that weak, how can a central bank strategy to corral consumer price inflation predicated on pushing rates up have any hope of being at all efficacious?
Given that the ECB, the BoE, and the Fed have all made the same observation about inflation in their rate hike announcements—i.e., that consumer price inflation is still “too high”—the data also strongly suggests that the preferred strategy, the “prevailing wisdom” since Paul Volcker tilted at the inflation windmill in the early 1980s, is far from a guaranteed way to bring inflation down.
Albert Einstein once pithily observed that “in theory, theory and practice are the same. In practice, theory and practice are different.” While he was referring to particle physics, the truism applies just as well to economics and interest rates.
Interest rate practice still beats interest rate theory. Every time.
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