| Federal Reserve Chair Jay Powell wrapped up semiannual testimony in front of Congress yesterday. Overall, Powell’s testimony went as expected, as the Fed chair remained dovish and appeared comfortable with rising rates. Subsequently, the nominal U.S. 10-year yield moved up to 1.47%, the highest level this year, before pulling back slightly. |
When it comes to how the Fed assesses a rise in long-term U.S. interest rates, it is most important to look at why rates are rising. Thus far, the Fed and the markets sees rates being driven by “healthy” factors, as yield reflects improving macro fundamentals amid COVID-19 vaccine progress, a slowly recovering economy and increased expectations for fiscal stimulus. The complicating factor is that the current recovery isn’t like past recoveries.
Never in history has the markets seen such a big, coordinated double dose of super-easy monetary and fiscal policy, and this raises the risk of a boom-bust cycle. Despite unemployment dropping from a peak of 14.3% to 6.3%, the Fed has shown no sign of withdrawing stimulus. On the fiscal side, the Biden administration has proposed a repeat of the 13% of GDP stimulus from last spring, when the economy was in a historically sharp contraction, with an even bigger infrastructure package to follow. Of course, there is also the trillions of dollars in excess savings that should be unleashed once the economy reopens. Granted, inflation has been very sticky in recent years, but this doesn’t rule out the possibility of a surge due to a supply-constrained reopening, as a simple supply-and-demand framework shows.
The aggregate demand curve is fairly straightforward. It is downward sloping to the right, as lower prices lead to higher demand. Fiscal and monetary policy tends to shift the demand curve to the right, meaning more quality is demanded at all price levels. The aggregate supply curve is a bit more nuanced. As expected, the supply curve is upward sloping to the right, as higher prices encourage firms to supply more goods and services. However, as the economy approaches full employment and potential output, the slope of the supply curve steepens. That is, the inability to produce more goods and services causes a sharper increase in prices.
The concern is that the U.S. economy could hit this steeper part of the supply curve as demand surges due to massive fiscal stimulus and the reopening of the economy, but short-run supply constraints, such as businesses that have closed for good, limit the supply side. The hope is that years of low and sticky inflation mean that price increases will come slowly and give policymakers time to adjust. But with all the stimulus coming, the risk is for upside-growth surprises that could compel policymakers to hit the brakes hard, increasing the risks of a policy mistake. But for now, optimism on potential growth with the jobs market is providing some good news, as initial jobless claims beat expectations, coming in at 730,000 versus expectations for 825,000 claims.
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