Forward Guidance Says Rates to Remain as-is for an “Extended Period”

Presidents Day - Bond Market

time-to-evaluate-ssIf you follow the forward guidance of two of the world’s most important central banks have suggested that short-term interest rates in their domain will remain where they are for “an extended period” of time.

Signals coming from the Federal Reserve System in the United States suggest that short-term interest rates will remain at or close to current levels until the middle of 2015.  The effective Federal Funds rate, the policy rate of the Federal Reserve has averaged around nine basis points for most of this year.

The Federal Reserve will cease its current policy of quantitative easing in October.  The question is, when is the Fed going to oversee a rise in short-term interest rates?

The European Central Bank has suggested that short-term interest rates will remain as low as they are now until “late 2016.”

The ECB is facing a environment in which the eurozone may slip back into another period of recession with the real possibility that the area may begin to experience a period of deflation.

As a consequence, the ECB is considering a purchase plan that would include buying asset-backed securities.  This seems to be its plan for stimulating more economic activity.

In the United States, the 10-year US Treasury bond rate has been hanging around the 2.50 percent level, way below most predictions for the year.

In Europe, the 10-year German bund is hanging around 1.00 percent a historical low for the European Union, while the Netherlands, Spain, and France also remain around historical lows.

The low interest rates, in my mind, are not due, primarily, to the actions of the central banks.

Short-term interest rates can be impacted by central banks but only for a limited amount of time.  In usual cases, after a central bank acts to move short-term interest rates, market forces begin to react to take rates back to where they were.

In order for the central bank to keep rates at the new lower…or higher…rate, it has to keep taking more and more action or otherwise the short-term rate will revert to its former level.

Why, then, have short-term interest rates stayed so low for so long in the United Stats and in Europe?

My answer to this is that American economy…and the European economy…has been so weak that there has been very little demand for money.  That is, there is no demand pressure for short-term interest rates to rise.  The lack of demand pressure is due to the fact that the economies of these areas have been so week.

If this is the case, then, to me, the “forward guidance” given us by the Federal Reserve System and the European Central Bank is that the economies in each area will remain weak enough so that there will be little demand for funds creating pressure for short-term interest rates to rise.

In other words, these central banks are not expecting strong economic growth, at least strong enough to put upward pressure on short-term interest rates, to come about until…the middle of 2015 for the United States…and late in 2016 for the European Union.

These are not very optimistic projections.

What about longer-term interest rates?

My belief is that a central bank has very little it can do to effect longer-term interest rates.  It can possibly influence inflationary expectations, but this tends to be something that can happen only over time.

Savings rates or investment rates or major movements in investor preferences can have much more impact on longer-term interest rates than can the central banks.

For example, I have written several times in LearnBonds posts about how the “risk averse” behavior of investors from Europe have sought out American securities as a “safe haven” for their money and have had substantial impacts on longer-term US Treasury issues.

The flow of funds from Europe drove the yield on the 10-year Treasury Inflation Protected bonds into negative territory in August 2011 and kept it there until June 2013.  The Federal Reserve did not cause this situation to occur.

Currently, the longer-term interest rates in both the European Union and the United States are very low.  Analysts claim that these rates are low because inflationary expectations both on the European continent and in America seem to be quite low.

It is reported that the measure of inflationary expectations used by the European Central Bank is now around 1.9 percent to 2.0 percent.  This is the expected compound rate of inflation for five years.

In the United States, I estimate that inflationary expectations are in the 2.1 percent to 2.2 percent range.  This is the expected inflation over the next ten years.

Again, we are seeing in both cases the impact of expected slow economic growth in the foreseeable future.  Many, in Europe and in America are concerned that the near future might contain the possibility that the eurozone and the United States might experience what the Japanese have been going through over the past decade or so.

We, in the United States…or in Europe, for that matter…have never faced a situation like this in our professional careers.  It seems as if so much is riding on the possibilities for economic growth…or the lack of it.  And, we just don’t know when we will start to experience faster economic growth.  We just have to keep our eyes open.

About John Mason
 John MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.

All trading carries risk. Views expressed are those of the writers only. Past performance is no guarantee of future results. The opinions expressed in this Site do not constitute investment advice and independent financial advice should be sought where appropriate. This website is free for you to use but we may receive commission from the companies we feature on this site.
HTML Snippets Powered By : XYZScripts.com