Fed raises rates, but we're not going back to the 1980s
16 March 2017 | Joe Davis
The US Federal Reserve Board met on 14 and 15 March. As expected, the Fed raised its key interest rate target by 25 basis points (0.25 percentage point). The case for a hike was strong:
- The United States is more or less full employment.
- Inflation, which has slowly accelerated, hovers near the Fed's 2% target.
Vanguard expects two to three rate hikes by year-end, which would put the federal funds rate at 1.25%–1.50%, a level consistent with the Fed's – and Vanguard's – assessment of the US economy's strength.
The more interesting, and puzzling, economic analysis concerns what is happening in the equity market.
US equities have been on a tear. The market is priced for long-term economic growth rates of 3%-plus; maybe 4%. (This estimate is based on our calculation of the earnings growth estimates implied by current stock prices.)
But like big hair and New Wave music, those growth rates are an artefact of the 1980s. These days, the labour force is increasing slowly. Productivity growth, which could be turbocharged by a 21st-century innovator like Thomas Edison or Henry Ford, is for now modest. And we've sworn off the growth-boosting but risky leverage that inflicted so much pain in the global financial crisis. The US economy's long-term potential growth rate is about 2%.
Where we were, where we are
We can see the economic differences between the 1980s and today through the lens of bond yields. (This analysis comes from Vanguard's 2017 economic and market outlook.
During the 1980s, the 10-year US Treasury note yielded an average of more than 10%. At the end of 2016, it yielded 2.5%. The following drivers, illustrated in below, explain the change:
- Lower inflation. In the 1980s, US prices rose at an annualised 5% per year. A cart of groceries that cost $100 (about £80) at the start of the decade cost more than $160 (about £130) at the end. Today, inflation is barely 2%.
- Slower productivity and labour-force growth. An ageing population means slower labour-force growth. And workers' hourly output is increasing more slowly – a rate of 1.6% per year in the 1980s, about 1% today. (That's not bad! Before 1700, Europe experienced no productivity growth. As a result, a farmer born in the 14th century had the same standard of living as his great-great-great-grandson born in the 17th, though the latter did have Shakespeare.)1
- A lower term premium. The term premium measures the additional yield paid by longer-term bonds relative to shorter-term bonds. It's related to inflation risks, which have declined significantly.
- Greater demand for US bonds. The remaining drivers are increasing global demand for the world's safest asset – the US Treasury note – and unexplained (residual) causes.
Drivers of US interest rates since the 1980s
Decline in inflation has been the key
Notes: The decomposition of changes in real equilibrium interest rates is based on the sequential application of three models, which are presented in the sources. Source: Vanguard calculations based on data from Holton, Laubach and Williams (2016) and the US Congressional Budget Office Budget and Economic Outlook (2016).
No time machine
Maybe new fiscal policies – tax reform that boosts investment, infrastructure projects that produce economic efficiencies – will nudge growth higher. Uncaged "animal spirits", evident in business and consumer confidence surveys, could put near-term US growth at 3%. But none of the new White House administration's proposals include a time machine that will take us back to the 1980s.
Our asset class forecasts, anchored on a future of 2% US growth, assign the highest probabilities to:
- Global bond market returns of 0%–2% over the next decade.
- Global equity returns of 5%–8% over the next decade.
For the moment, the US equity market is giddier, suggesting a different economic future. Our advice: Stick to your target asset allocation, even as share and bond prices swing with changing sentiment. Rebalance to that allocation as necessary. We're not going back to the 1980s. The calendar and the outlook have changed.
1 Piketty, Thomas, and Arthur Goldhammer (translator). Capital in the Twenty-First Century. Cambridge, Mass.: Belknap, an imprint of Harvard University Press, 2014. P. 94.
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