Central Bank Watch - September 2024

For most of the 20th and 21st centuries, the global economy has become a debt-based monetary system. In this system, money is essentially loaned into existence primarily by commercial banks, and through “money printing” by central banks. Further, collateral such as US Treasury debt is also used to increase leverage in the “Shadow Banking” system. In this system, central banks and governments do all they can to prevent deflation. Deflation in this context is simply the destruction of credit or debt leading to falling prices. Keynesian economics is the prevailing wisdom in today’s central banks. Nearly 90 years ago, John Maynard Keynes argued that if the private market chose to save for a rainy day thus reducing “demand,” this could lead to higher unemployment and lower economic growth. Therefore, the government should intervene in the absence of private demand by stimulating economic growth through government spending (fiscal policy) or lower interest rates (monetary policy). Per Keynes, “the State” must intervene to prevent booms and busts.

Therefore, central bankers will do all they can to avoid deflation in today’s economy. This includes a consistent positive level of price inflation (CPI), encouragement of economic growth, and higher stock and bond markets. Deflationary shocks, all too common since 1913, arguably are ultimately what central bankers most want to avoid. With this as a backdrop, let’s review what occurred during yesterday’s Federal Reserve meeting.

United States

Yesterday, the U.S. Federal Reserve lowered the benchmark interest rate by 0.5% to a target rate of 4.75% to 5.0%. The debate raged before the meeting whether or not they would cut rates by 0.25% or 0.5%. Looking at the US Treasury yield curve, the bond market has moved well in advance of today’s decision by the Fed. The 2-year US Treasury note is a great benchmark to watch for a potential endpoint of the Fed Funds target rate once this current easing cycle ends. As of this writing, the 2-year has dropped from 5.25% in October 2023 to its current rate of 3.60%. Below is a chart plotting the fed funds rate with the 2-year since 2000.

Figure 1: Federal Funds vs. 2-Year U.S. Treasury

Source: TradingView

With price inflation “under control” and heading south, the Fed is much more concerned about its mandate to maintain full employment.

As a reminder, the Federal Reserve is tasked with the following mandate:

1. Price Stability - Their target is a 2% price inflation
2. Maximum Employment
3. Stability of Financial Markets

The Congressional Budget Office (CBO) released a report in June 2024 that forecasted future budget and economic projections. In this report, they noted

“The unemployment rate ticks up to 4.0 percent by the end of 2025, rises to 4.5 percent in 2030, and declines slightly thereafter.” 

See figure 2 below. With the unemployment rate now at 4.2%, the Fed has all it needs to start lowering rates.

Figure 2: CBO Projections of Unemployment

Source: Congressional Budget Office

Real Interest Rates

By raising interest rates in 2022, the Fed ushered in a stronger dollar and positive real interest rates as investors sought the safe haven of U.S. capital. Higher interest rates thus meant rolling over U.S. government debt at 1-2% for debt at 4-5%. This led to higher overall debt levels and higher interest payments as a percentage of the government budget. With $35 trillion in government debt, you better believe a lower level of interest rates is welcome! Figure 3 below details 100 years of inflation and 1-year interest rates as measured by the 1-Year US Treasury note.

As seen below, outside of the great depression in the 1930s, World War II in the 1940s, and two brief periods following recessions in 1950 and 2008, inflation remained in positive territory. Pay close attention to the blue line since the 2008/2009 global financial crisis. Negative real interest rates enable highly indebted governments to pay off debt at a quicker pace. This was the game plan employed by the United States following World War II. Will we see a repeat of this strategy in the years to come?

Figure 3: Real Interest Rates - Last 100 years

Source: Longtermtrends.net

Global Central Banks

The European Central Bank cut interest rates earlier this month due to sluggish economic growth and lower inflation. GDP growth grew at a paltry 0.2% in the second quarter of 2024. Estimates by the ECB have the inflation rate cooling to below their 2% target next year.

China continues to fight deflation on multiple fronts. GDP growth has slowed dramatically since the early 2000s when it routinely clocked in around 10%. GDP growth has steadily declined since 2009 and is now hovering around the 5% level. Much of this drop has to do with overinvestment in their economy, specifically in the real estate market which has deflated in recent years. Their stock market has also declined and is now sitting at a Schiller Price to Earnings ratio of 10x. Their fixed exchange rate policy persists and debt is growing as a result now over close to 300 percent of GDP. As is common with a debt-based monetary system, the currency devalues versus gold. True to form as seen in Figure 4 below, the Chinese Yuan has lost 59% of value vs. gold in the past 10 years. It’s no wonder that demand for gold from China, both from the central banks and its people, has been robust in recent years. 

Figure 4: CNY/Gold 10-Year

Source: fxtop.com

For current central bank rates and more general economic indicators covering the U.S., China, and the EU, see the tables below.

References

References

• An Update to the Budget and Economic Outlook: 2024 to 2034. (2024). Congressional Budget Office.
• The Real Interest Rate. (2024, September 15). longtermtrends.net. https://www.longtermtrends.net/real-interest-rate/
• https://fxtop.com/
• TradingView
• CEICdata.com

DISCLOSURES & INDEX DESCRIPTIONS

For disclosures and index definitions please click here.