Rates and Reflation

Episode Summary

Executive Summary: Moody’s Analytics economists discuss recent indicators, including a forecast surge in U.S. personal income and a sharp drop in CO2 emissions, then focus on interest-rate outlooks. They debate why long-term yields may rise over time, weighing inflation, global capital flows, Fed QE, and the pace of labor-market recovery, while agreeing the path higher is likely but timing is uncertain.

Main Topics: Weekly indicator highlights (Priority: 4/5): Chris highlights Japan’s 10-year government bond yield; Ryan forecasts a record jump in personal income driven by stimulus checks and expanded unemployment benefits; Mark cites planned CO2 emission reductions. Personal income and stimulus effects (Priority: 5/5): Ryan argues March personal income will surge because of transfer payments, helping explain strong retail sales, vehicle sales, and the broader boom-like economic data. Climate policy shift and emissions target (Priority: 3/5): Mark emphasizes the Biden administration’s climate agenda and the U.S. commitment to cut CO2 emissions 52% by 2030, framing it as a major policy reversal from the Trump era. Inflation outlook and its link to rates (Priority: 5/5): The hosts compare forecasts: Ryan sees inflation staying modest, Chris expects a Goldilocks overshoot above target, and Mark takes the high side, arguing inflation feeds into interest-rate expectations. Long-term Treasury yield outlook (Priority: 5/5): The core debate centers on where the 10-year Treasury yield will be three years out, with forecasts ranging from 3% to 4%, and whether nominal GDP growth should anchor long-term yields. Fed policy, QE, and labor-market normalization (Priority: 5/5): Ryan explains the Fed’s new flexible average inflation targeting and its emphasis on actual data; he and Chris argue QE and global demand can suppress long-term yields. The group discusses full employment timing and when rate hikes may begin.

Key Arguments: Stimulus payments and expanded UI benefits should produce a record increase in personal income, which will support consumer spending and the March rebound. The Biden administration’s 52% CO2-reduction pledge reflects a major policy shift and will drive tighter scrutiny of climate risk, especially for financial institutions. Forecasting interest rates is inherently difficult because they are asset prices influenced by fundamentals, sentiment, and technical factors. Mark argues 10-year Treasury yields should converge toward nominal GDP growth because the yield is the economy’s cost of capital and nominal GDP is the return on capital. Chris counters that global investors and foreign reserve demand for Treasuries can cap U.S. long-term yields below nominal GDP growth. Ryan adds that QE and the Fed’s enlarged balance sheet likely keep term premium near zero or negative, suppressing long-term rates. The Fed’s new flexible average inflation targeting framework makes it more tolerant of inflation overshoots and less focused on unemployment thresholds or forecasts. Ryan sees full employment returning only in early 2024, based on the prime-age employment-to-population ratio; Chris expects end-2022; Mark lands in between, late 2022. The Fed is expected to begin raising short-term rates once inflation is clearly above target and labor markets tighten, with Mark calling for a January 2023 first hike. The hosts ultimately agree long-term rates likely rise over the next few years, but path dependence and policy/global factors make the exact level uncertain.

Data Points: Japanese 10-year bond yield: 7 basis points - Chris’s weekly indicator; he used Japan’s 10-year government bond yield as a shout-out to the podcast’s Japanese audience. Forecast increase in personal income: 21.5% - Ryan’s prediction for March personal income, driven by stimulus checks and expanded unemployment benefits. U.S. CO2 emissions target reduction: 52% - Mark cites President Biden’s goal to reduce U.S. emissions by 52% by 2030. Global excess saving estimate: Over $5 trillion - Mark references his estimate of excess saving worldwide in Q1 2021. U.S. share of global excess saving: About $2.5 trillion - Mark says the U.S. accounts for roughly half of the global excess saving total. Current 10-year Treasury yield: About 1.5% - Mark describes the benchmark long-term rate at the time of the discussion. Pandemic-era low for 10-year Treasury yield: About 0.5% - Mark notes the 10-year yield fell to around this level in late August of the prior year. Forecast 10-year Treasury yield in 3 years: 3%–3.5% - Ryan and Chris each place the yield in this range. Mark’s forecast for 10-year Treasury yield in 3 years: 3.5%–4% - Mark takes the high side relative to Ryan and Chris. Long-run nominal GDP growth assumption: 3.5%–4% - Mark’s framework for why long-term yields should rise toward nominal growth. Inflation assumption in Mark’s framework: 2%–2.5% - Used with real GDP growth to derive nominal GDP growth. Real GDP growth assumption: 1.5%–2% - Used by Mark to derive nominal GDP growth. Prime-age employment-to-population ratio gap: 4 percentage points below pre-pandemic - Ryan uses this to argue the labor market is not yet back to full employment. Prime-age EPOP benchmark: Around 80% - Ryan says reaching this level is a useful rule of thumb for full employment. Fed first rate hike expectation: Q1 2023 - Mark says markets expect the first hike in early 2023. Cumulative rate hikes in 2023: 75 basis points - Mark says this aligns with his baseline forecast and market expectations. End of full-employment recovery estimate: Early 2024 - Ryan’s forecast for when the economy returns to full employment. Chris’s full-employment estimate: End of 2022 - Chris initially says he expects the labor market to recover faster. Prime-age employment threshold: Above 80% - Mark links this threshold to wage acceleration and emerging price pressures. Podcast length guidance: No more than 40 minutes - Mark says there is conventional wisdom that podcast episodes should not run longer.

Pivotal Quotes: "Forecasting interest rates is pretty difficult, very difficult." — Mark Sandy: Mark opens the main topic by emphasizing humility and uncertainty in rate forecasting. "The Fed's basically committing that we're going to do everything we can to make sure inflation overshoots for a period of time our 2% inflation target." — Ryan Sweet: Ryan explains the Fed’s new flexible average inflation targeting framework. "I think the 10-year Treasury yield in the long run should be equal to the nominal growth in the economy." — Mark Sandy: Mark presents his key framework for the long-run Treasury yield outlook.

Implications: Listeners should expect interest rates to trend higher over the next few years, but not in a straight line. Fed policy, inflation, global demand for Treasuries, and labor-market healing will shape timing and magnitude.