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Recent Rise in Real Interest Rates Could Jeopardize US Economic Recovery


Low real yields accompanied by sufficient nominal growth are the necessary prescription for a still-ailing economy.

Consistency Is Key

One could easily make the case that the Fed is still expanding its balance sheet four years into the quantitative easing (QE) program because it has been reluctant to fully commit to its intention to kick-start the deleveraging process by maintaining low real interest rates and higher inflation expectations.

The first QE program in 2009 caused long-term inflation expectations, as measured by the 10-year breakeven inflation rate (BEI), to recover from nearly 0% to 2% (see Figure 2). Since then, the Fed has not really been consistent, and has rushed to exit QE as soon as 10-year inflation expectations reached 2.5%.

Every year since then, the Federal Open Market Committee (FOMC) has talked about exiting and reducing its balance sheet at the end of the first quarter in response to the perception of improving data and rising inflation expectations. In 2010, 2011, 2012 and now 2013, the Fed backpedaled as 10-year breakevens rose above 2.5%. There is seasonality in the economic data, in the oil market and in the flow of funds into inflation protection mandates at the beginning of every year. The Fed has been reacting hawkishly to this, pushing 10-year inflation expectations down and real interest rates up. This in turn slows the US economy, forcing the Fed to ease again and increase its balance sheet even more.

To lower real interest rates and ignite animal spirits by pushing up inflation expectations, the Fed needs to "promise to be irresponsible" until the US economy is well in the clear – and everyone needs to believe it. The Fed attempted this when it announced that rates would stay at zero for as long as inflation was below 2.5% and the unemployment rate was above 6.5%, and that it would continue its commitment to asset purchases. The economy then started to show some signs of improvement. But with core personal consumption expenditures (PCE, the Fed's favorite measure of inflation) at a record low 1.1% year-over-year rate and with modest growth and employment improvements, the market did not expect the Fed to once again talk about tightening monetary policy. Despite fiscal tightening and record low inflation, it looks like stability in the housing and stock markets was enough for the Fed to start thinking about reducing accommodation.

The argument that it is the size of -- and not the change in -- the balance sheet that matters is seriously challenged by the recent move in both mortgage and real interest rates. It's just arithmetic, as President Clinton once said. Less accommodation is a de facto tightening.

The market may now be at the stage where it has started to challenge the will of the Fed to reflate the economy out of the liquidity trap. This could lead to negative consequences for the real economy, resulting in a malaise like we've seen in Japan.

The Fed's Dilemma

As the economy improves, the Fed has fewer incentives to maintain the promised excessive accommodation and has to fight the perception that it will pull back too soon. But to push investors out into taking more risk, the Fed's commitment has to be credible.

When rates are already at the zero lower bound, there is no time for mistakes. Bernanke should be comfortable with high inflation expectations and very uncomfortable with dropping inflation and nominal growth. Tapering too soon, if it ends up being reversed later, could be a very costly mistake that would lead to a larger, not leaner, Fed balance sheet.

This article originally appeared on PIMCO.
No positions in stocks mentioned.
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