Last week, I got calls from viewers who were worried about the selloff in US 30 year bonds. They were worried that this must mean a major surge in US inflation. The reason was that US 30 year bonds had sold off to well over 5%. They had gone up to 5.19% and then fallen back again to 5.03%.
Does this mean the beginning of a major surge in inflation in the US? What I then did was look up US inflation expectations on the Federal Reserve Economic Database. I found that there had been an increase in 30 year inflation expectations from 2.37% up to 2.51%. This is tiny.
It is interesting because 2.5% is the inflation target of the RBA. So all of that actually happened in the US as inflation expectations had gone up to the RBA target. I thought that really was not something that was going to be an extreme problem for the US economy.
This brings me to my models of the Fed funds rate and the Australian cash rate. I will talk about the Australian cash rate first. At the beginning of the year, we forecast that the Australian cash rate would go up to 4.85% by the end of the year. This was much higher than the market thought at that time. That was based on our model of the Australian cash rate, which we have had operating since the 1990s. The data series starts in January 1990 and explains 89.4% of the variation in the Australian cash rate since then.
What it says now is that the equilibrium cash rate we anticipate by the end of the year is 4.84%, which is still about half a percent higher than current rates. So we think there will be two more rate hikes by the end of the year, likely by the RBA meeting on 2–3 November, taking rates up to 4.85%. The reason for that is that core inflation in Australia is higher than anticipated. A lot of that is not due to the war in the Middle East, but rather very high electricity prices in Australia.
Returning to the US, our model there shows that compared to an actual Fed funds rate of 3.6%, our model estimate is 3.73%, which is only slightly higher. That is not enough to generate a rate hike. We think the Fed funds rate will stay largely where it is. However, over the next six months we still expect more rate hikes in Australia.
Another factor that may prevent or slow rate hikes in the US is the incoming Federal Reserve Chair, Kevin Warsh. Over the past year, Warsh has been arguing that the Fed balance sheet is too large. As a result, instead of raising the Fed funds rate, Warsh is likely to reduce the Fed balance sheet. This means government debt will be financed less by the Federal Reserve and more by private banks. Warsh wants to do this to impose more discipline on government spending.
As this process unfolds, the reduction in Federal Reserve holdings of government debt means more of that debt is taken up by the private banking sector. This, in turn, reduces the ability of banks to hold large amounts of private debt. Over time, this places pressure on financing private debt and private equity. This is intentional, as Walsh believes these assets should move back to public markets where risks are easier to assess.
By doing this, the policy reduces the likelihood of an off market crisis like the asset backed securities issues seen in 2007 and 2008.
Monetary policy in the US may therefore tighten, but primarily through quantitative tightening rather than interest rate hikes.
This will put pressure on private debt and private equity, pushing financing back onto public markets over time.
Want to discuss how this impacts your portfolio?
DISCLAIMER: Information is of a general nature only. Before making any financial decisions, you should consult with an experienced professional to obtain advice specific to your circumstances.
