Plummeting Rates – an Inflation Fight Challenger?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Federal Reserve Bank of St. Louis President James Bullard spoke today at the Arkansas Bankers Association. Before I knew that this was happening, I produced the following graph:

I’ve been wondering how the massive shift down in the Treasury Yield Curve would impact the Fed’s action in its battle to control stubborn inflation. As you can see, despite massive “tightening” since March 17, 2022, long rates haven’t budged much. They had peaked at higher levels prior to Silicon Valley’s implosion and fear of a greater banking crisis drove market participants to seek a flight to safety. Incidentally, Bullard addressed this very issue in today’s talk. He stated that “financial stress can be harrowing, but one corresponding effect of note is that it tends to reduce the level of interest rates”. He continued, “Lower rates, in turn, tend to be a bullish factor for the macroeconomy”. In the four weeks since SVB’s demise, the 10-year US Treasury yield has declined by 50 bps, while the 2-year Treasury yield has declined by more than 100 bps.

Bullard also spoke about the macroprudential policy response which he described as “swift and appropriate”. For those of you like me, who might not have understood what macroprudential meant, it is “of or pertaining to systemic prudence, especially to the strengths and vulnerabilities of financial systems.” Obviously! He wanted to reassure everyone that the financial metrics of today remain low compared to levels that were observed during the GFC or during the beginning stages of Covid-19. That’s comforting!

However, he did go on to say that the US economy produced a stronger GDP in the second half of 2022 than was forecast, while 2023 looks to be relatively strong with the GDPNow forecast for the first quarter at 1.7%. Furthermore, inflation remains too high. Core PCE and the Dallas Fed’s trimmed mean inflation measures have declined, but by less than the headline measures. It appears to us that the Federal Reserve still has plenty to do to stabilize prices. The banking system may have scared many of us, but a strong labor force, decent wage growth, and falling US interest rates may just be keeping the current inflation environment stickier than the Fed wants to see.

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