The Intricacies of U.S. Interest Rates and Economic Outlook – 09 AUG 2023

To emphasize the importance of monitoring the U.S. 10-year Treasury yield

I continue to emphasize the importance of monitoring the U.S. 10-year Treasury yield. The primary reason for this focus is rooted in our perception of the future, as highlighted in the currency-related discussions we had over the past weekend. However, this consideration also extends to the realm of interest rates. Many individuals tend to assume that as the exchange rate is currently highly elevated, it will eventually decrease, and similarly, interest rates will decrease due to the impact of inflation, leading to a decline in prices.

Yet, if everyone shares the belief that interest rates will decrease, will that future scenario indeed materialize? Earlier this year, when there was a widespread mention of an economic downturn, the pendulum swung to the opposite extreme, with expectations rising for a pivot. The adage ‘every cloud has a silver lining’ resonated in asset markets, sparking rapid ascent, which helped sustain consumption and postponed an economic slowdown. As the projected downturn failed to materialize, the notion of a pivot diminished.

We have seen a continuous series of interest rate hikes, starting from 4.75% and progressing to 5.0%, and then to 5.25%. Regardless of our sentiments, interest rates have gradually climbed to 5.5%. A similar perspective applies here. Is 5.5% a high interest rate? This question serves as a pivotal point distinguishing the hawks from the doves within the Federal Reserve. In comparing the present interest rate to historical contexts, 5.5% might appear as a significantly elevated figure. However, the Federal Reserve assesses whether this rate level indicates a significant tightening or not. The concept of the neutral rate comes into play. If the current rate is significantly above this neutral level, it implies a tightening. Moreover, for the Fed’s stance to be adequately tightened, inflation or growth must contract at a faster pace.

The U.S. inflation rate still exceeds the Federal Reserve’s target.

The U.S. inflation rate still exceeds the Federal Reserve’s target. While the Consumer Price Index (CPI) experienced a decline to 3%, it remains well above the 2% target. The Core Consumer Price Index suggests that the journey towards price stability is still a considerable distance away. While the decline in headline inflation may appear swift, the decline in core inflation is notably gradual. Some may argue that the decline in energy prices contributed significantly to this swift headline decline, making it challenging to attribute it solely to interest rate hikes.

If inflation does not abate quickly, then one could question whether 5.5% or even higher is indeed a tightening rate. This perception conflicts with the idea of tightening. Yet, as conditions remain robust with minimal economic slowing and stable unemployment rates, the debate intensifies. Critics emphasize that although 5.5% seems high, patience is required for the effects of rate hikes to fully manifest. The argument is that rate hikes don’t have an immediate effect but rather work with a time lag.

In summary

In summary, the discourse centers around the question of whether 5.5% is truly a high interest rate. However, the more critical focus should be on how long the current high interest rate will be maintained. This debate divides the hawks, who advocate for additional rate hikes, and the doves, who believe that patience is needed. The Federal Reserve’s choice will significantly impact the trajectory of future rate adjustments. The nuances of this discussion will undoubtedly shape the economic landscape in the coming months. We will continue to observe these developments closely and analyze their implications. Thank you for reading.

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