Krugman: interest rates will fall...eventually

I’m often dubious about Paul Krugman, since his opinions are often tinged by his political slant. For example, he was on “Team Transitory” regarding inflation in 2021, which he has since regretted. But, since he won a Nobel Prize in economics, I read his columns while maintaining my own independent thinking.

Krugman has learned a little humility from his inflation mistake but he does make some good points.

Wonking Out: Why Interest Rates (Probably) Won’t Stay High

By Paul Krugman, The New York Times, Nov. 18, 2022


I still believe that rates will eventually revert to their lows of the 2010s, even though rates have risen since I made that argument. [Shucks, just like inflation rose after Krugman made the argument that it would recede. --W]…

The Covid-19 surge in deficits is now behind us. Those C.B.O. estimates do say that deficits will remain somewhat high by historical standards, but nowhere near the levels they hit in 2020-21. …Eventually, the boost to the economy from pandemic aid will fade away. And once that happens, we’ll probably be back where we were before the pandemic, with weak private investment demand holding interest rates down…

One well-known concept in macroeconomics is the accelerator effect. This says that investment spending generally reflects not the level of G.D.P. but the expected change in G.D.P. The logic is that investment spending is only high when businesses want to increase their capacity, which happens only when demand is growing…

[snip demographic reasons why demand isn’t growing and the CBO’s prediction of 1.5% annual GDP growth]

A few years from now, we’ll probably be back to a situation in which too much saving is chasing too few investment opportunities, and interest rates will be revisiting their old lows. [end quote]

OK, I buy the argument that growth will slow due to demographics (growing retired population, fewer workers since birth rates and immigration have dropped).

But the ultra-low interest rates were forced by the Fed in response to crises. After this inflation scare abates (which may take longer than anyone expects) the Fed intends to target a neutral fed funds rate, not a stimulative rate. That puts a higher floor under all rates.

Without the Fed’s massive monetary stimulus all assets (stocks, bonds, real estate) will lack the constant growth in prices. Government borrowing will crowd out productive borrowing, pushing long-term interest rates higher.

So, Krugman may be right. Interest rates may fall, eventually. But it may take longer than he expects (he didn’t publish a timeline) and the rates may normalize to their historic pre-2000 real level of about 2% over inflation.

Wendy

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Talking heads are saying they expect the Fed to keep raising rates until rates exceed the inflation rate. Inflation rate was 8+% for two months; last time 7+%. Current interest rate is 3.5 to 4%. Some say crossover could be as low as 5%, but many think 6% is more likely. Timing is uncertain but probably not until Spring.

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Thanks for the good info.

With the current yield curve inversion it’s easy to stay short-term until the spring. I just bought a secondary-market TIPS yielding 2.5% + inflation, maturing 4/15/23.

When it looks like rates have hit a peak it will be time to go longer. But the yield curve inversion also means that the longer term yields are lower than the short-term yields. I would buy 10 year TIPS if their yield was 2% or higher, which hasn’t happened since 2008.
Wendy

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Wendy,

I agree with you. I will go a step further he has no clue. A stuck clock is right twice a day. I am not sure he will be right once a day. He cant help it but he is shifting the hands on the face of his clock.

We are entering a period where even with fiscal policy leading compared to the 1950s monetary will play more of a role. One reason is the retirees getting a return on fixed income is consuming and savings power. Another reason holding asset prices slightly in check is more balanced than letting asset prices inflate the wealth effect. Another reason the US Treasuries issued this decade can not echo the low coupon rates of the 1950s and the catastrophic reaction in the economy of an unchecked inflation rate in the 1970s. There is a long game here that is very sought after of a 30 to 40 year demand side economics for the US.

Demand side long vilified was a cheap dumb way of arguing tax breaks for the 1% over taking a whit of care for our nation. We need to create massive wealth in this nation with inflation kept at bay.

I also bought one, but I am considering selling it early. That’s because there is a reasonable possibility of a month or even two of negative inflation. The way I understand it is that it (negative months) will reduce the principal value of the note at maturity. Is that correct?

That is correct. The principal of a TIPS is pegged to the CPI which can drop in case of negative inflation. But…

Let me share a different perspective.

Negative inflation is very rare. The only time it has happened was during severe financial crises, notably 2008 and 2020. Take a look at this chart and you will see the actual blips of negative inflation embedded in decades of positive inflation. That only has happened during severe, sudden crises.

These blips of negative inflation are an opportunity to buy TIPS, not sell them, since the bond market is usually in a frenzy.

I bought 10 year TIPS in October 2008, when the yield was 3%. That was an opportunity that has never occurred again. If the 10 year TIPS yield rises to 2% in 2023 I will buy. I think that the Fed and the market won’t allow the plain 10 Year Treasury to rise to 2% above inflation as it was historically before 2000.

Wendy

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There’s the rub. I’m trying to figure out if the current inflation is “secular” (would have happened in the normal course of economic cycles) or if it was “induced” by COVID disruption followed by [too] rapid recovery in demand for goods and services. It is possible that secular inflation smoothes out slowly over time without much deflation in the interim, and it is also possible that induced inflation corrects itself more abruptly with some deflation until smoothing occurs. I don’t know, and I’m not an economist.

I wouldn’t panic sell in the depths of deflation, rather I was thinking of selling before that point, perhaps even during the next few weeks. I haven’t decided, and will probably do nothing since it is such a small part of my portfolio anyway. I really bought them (in the secondary market, having missed the recent auction) on a whim to see how fixed income trading work at that broker. I think I mistakenly chose the wrong price to bid because I was just playing around and thought that surely my bid would not be accepted, but it was, and now I am the proud owner of 10 July 2032 TIPS. Why did I buy those? Because those were the only ones on the list with a minimum order size of 10, the rest were minimum 100! I paid 92.30 because their coupon is only 0.625%, and it came with $21.84 accrued interest.

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Consider the aftermath of WWI and the flu: inflation, then recession. No price controls in the US during the war.

Inflation rate by year: 1916: 7.667%, 1917: 17.841%, 1918: 17.284%, 1919: 15.235%, 2020: 15.625%, 1921: -10.936, 1922: -6.162. 1923: 1.791%

GNP per capita, per year from 1919 to 1930 in a chart at this link. Noticeable recession in 1920 and 21.

https://eh.net/encyclopedia/the-u-s-economy-in-the-1920s/

I notice other parallels in the national mood compared to the 20s…

Steve

If you were buying on Fidelity, you can click on “Depth of book” and often find other offerings of the same bond with smaller minimum quantities. (At a slightly lower interest rate, higher price.) Look carefully because it’s not easy to find – just a little blue dot on the line of the bond and in small print on the order page. This can be the difference between passing over and buying a bond that you want at a smaller order size.

Wendy

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