GEORGIA POLITICS: It’s Congress, the president who are keeping rates high

As we prepare to enter a Presidential election summer, most economic news will be tied to the backdrop of the November race.  We’re used to reports of the “misery index” which ties the rate of inflation to the unemployment rate.  

The misery index was prominent in both Jimmy Carter’s win in 1976 and his loss in 1980.  A recession in early 1992 took George H.W. Bush from record post-war approval ratings to a loss to Bill Clinton. It was Bill Clinton’s advisor James Carville that coined the phrase “It’s the economy, stupid.” to laser focus the campaign and his candidate on what voters cared about most.

Foreign policy and related civil unrest have dominated much of the headlines over the last few weeks, but many voters will ultimately be asking themselves if they’re better off than they were four or eight years ago.  The Covid shutdown greatly complicates how voters will judge the answer to that question.

While the unemployment rate remains near historic lows, inflation remains stubbornly over the Federal Reserve’s 2% target rate.  There is political pressure coming from some like Massachusetts’s Senator Elizabeth Warren for the Federal Reserve to cut rates.  The Fed, to avoid the appearance of being overly political, traditionally tries to avoid rate adjustments close to an election.  

It’s with this backdrop that many who will now be covering economic news will start.  Many of them have backgrounds outside of economics.  In their desire to simplify the story for political consumption, many will miss some basic understanding of how parts of the economy work and/or are connected.  

We’re going to focus on one aspect of this for the remainder of this piece.  The Federal Reserve sets short term interest rates.  This can affect mortgage rates, but not necessarily the way one would expect, or is customarily reported.  It’s important to understand the difference, outside the lens of a political election or timeframe, for your own purposes as a voter, consumer, and/or investor.

The Federal Reserve sets short term interest rates.  They do this by setting a rate banks charge each other for overnight lending, as well as setting a target rate for very short term bond trading.  They do the latter as a participant in the open buying and selling of short term government debt.  

It’s not uncommon for those reporting on the Fed’s interest rate decisions to say “your mortgage rates will remain high, as the Federal Reserve left rates unchanged,” implying that the Federal Reserve sets mortgage rates.  Mortgage rates tend to follow rates of 10 to 20-year government bonds, as most mortgages are paid off within 7-10 years as homes are sold or the owner refinance their debts.

Right now, we’re experiencing what is known as an “inverted yield curve”, where short term bonds pay higher interest rates than long term bonds.  In normal economic conditions, investors in bonds demand a higher rate for long term debt to account for inflation risk.  The Federal Reserve is keeping short term rates artificially high in order to cool down the economy, thus reducing demand and easing inflation pressures.

The assumption that mortgage rates and thus housing prices will come down when the Fed cuts short term rates should not be universally accepted.  Despite having just experienced a generation of disinflation – when inflation and thus interest rates have steadily declined since the 1980’s – there is now once again a long term risk of steadily increasing inflation.  Investors in long term bonds are likely going to want to keep the premium they are currently getting on longer term debt to account for this.

In addition, we have a classic supply versus demand problem.  The Federal Government continues to borrow a historically large percentage of its annual expenses, even when the economy as measured by GDP growth is generally strong.  This means issuing new bonds, adding supply to the market.

At the same time, for both political and economic reasons, foreign central banks and investors have less desire and/or need to hold U.S. bonds.  Demand for our debt is decreasing as the supply is increasing.  This means lower prices for bonds, which gives us higher rates.

Each monthly bond auction of 10 and 30 year bonds are now providing record amounts of debt issuance.  On top of this, there are still funds appropriated from various Covid relief and stimulus programs not yet spent.  Politico reported last week that the Biden Administration is rushing to spend $1.6 trillion between now and January to keep a potential Trump Administration from cancelling these expenditures.  

That would represent adding approximately 5% to the national debt – and thus bonds outstanding – in the next 8 months.  That is a heck of a potential addition to supply when demand remains weak.

The Fed can still cut short term rates, which would lower the cost of the government’s debt service – now more than any other line item in the budget other than Social Security.  It’s up to Congress and the next administration to rein in deficit spending if we’re going to hope for a long term path to lower long term interest rates like we pay on our mortgages.