'Why are rates about to go up when there is no inflation?" cries a recent article in a national newspaper.
The short answer is that rising inflation is only one of the factors that may lead to an increase in interest rates. The other is elevated economic activity and, in my opinion, the reason that the U.S. Federal Reserve will raise the Fed funds rate in the United States as early as next month, barring any unexpected developments coming out of Greece or China.
Let me explain. The nominal interest rate is the reward one expects for making an investment. This reward consists of three subrewards.
First is the reward for postponing consumption for the future, i.e., the real interest rate; second is the reward for possible loss of purchasing power, i.e., the premium for expected inflation; and third is the reward for possible loss of capital, i.e., the risk premium – I will ignore the risk premium here as normally it does not apply when dealing with government bonds.
In the short run, the real interest rate is driven by the business cycle. When the economy expands, the real interest rate rises and when the economy contracts the real interest rate falls. Also, in the short run, inflation is driven by the heightened intensity of economic activity and the pressures it entails, among other things, on productive capacity and the labour and commodities markets.
For example, in May, 2013, Canadian government long bonds registered a decline of 3.1 per cent. U.S. Treasury bond prices declined even more, prompting many analysts to scratch their heads since inflation was nowhere to be found, arguing that "inflation statistics are at odds with the magnitude of recent losses in U.S. bonds."
At the time, I opined that inflation and inflation expectations had nothing to do with the decline in bond prices. Instead, bond price declines had to do with an increase in real interest rates prompted by signs of improved economic activity in North America. That is why the prices of real return bonds (which are inversely related to real interest rates) had fallen much more sharply than nominal long-term bond prices (which are inversely related to nominal interest rates). The May, 2013, decline in the value of the iShares Canadian Real Return Bonds was 4.9 per cent, much more than the decline in nominal government long bonds. This underperformance continued in the months that followed.
A similar picture has emerged over the past year in the United States, which is different from that unfolding in Canada.
The iShares U.S. Long Treasuries Bond prices have gone up by about 5 per cent since July, 2014, whereas the iShares U.S. TIPS Bond Index is down by about 2.5 per cent. The corresponding numbers for the Canadian markets are up by about 7.5 per cent and 4 per cent, respectively. The divergence in economic activity between the two countries is to blame.
The lack of inflation has benefited the nominal government bond prices and partly hurt real return bonds, which are supposed to be a good hedge against rising inflation, but given low inflation expectations, their attractiveness is lessened.
Low expectations about inflation have little to do with the weak performance of the real return bonds in the United States though. The chief reason real return bond prices are falling (or real interest rates are rising) in the United States is because the U.S. economy has been accelerating over the past year. On the other hand, this has not been the case in Canada, as the economy is treading water.
Since the markets have spoken, what is the Fed waiting for? Why is the Fed not raising its effective interest rate yet? According to the well-known Taylor rule, which stipulates by how much nominal interest rates should change in response to a change in inflation and economic activity, the interest rate set by the Fed should have stood by now at about 2 per cent as opposed to almost zero per cent – not because of a rise in inflation but simply because of a pickup in economic activity.
Now if economic activity also results in a pickup of inflationary expectations, then an even higher normalized nominal federal-funds interest rate should be called for. This seems to have been coming into focus recently given that the iShares Long U.S Treasury Bond prices (which were up on a year-over-year basis) are now down by over 3 per cent since May, 2015, while the iShares U.S. TIPS Bond Index is down only by about 1.5 per cent over the same period.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.
George Athanassakos