The Fed's dilemma: Short-term and long-term interest rates are both too high and also... too low

 Short-term interest rates are significantly higher while long-term interest rates are more stable, what should the Fed do?

The US Federal Reserve (Fed) still aims to reduce interest rates by the end of this year. For many households and small businesses in the US, interest rate cuts cannot come as soon as they expected. But for large companies able to tap the corporate bond market and investors benefiting from a buoyant stock market, the Fed's easing seems less necessary.

The Fed on Wednesday kept interest rates unchanged at 5.25%-5.5% - the highest level in more than two decades, and is expected to have three interest rate cuts this year.

Changes in benchmark interest rates have a strong impact on many short-term interest rates, such as rates on bank deposits and money market funds. But for longer-term interest rates, such as corporate bond yields, the impact may be less.

Many people believe that the Fed's target interest rate is at a limited level. For Americans, they only need to look at credit card interest rates to understand. According to the Fed, the average interest rate for commercial bank credit card packages in the fourth quarter of 2023 is 21.5%. This is the highest level in 30 years and much lower than the 14.9% level in the fourth quarter of 2019 - before the pandemic struck.

Recent research by former U.S. Treasury Secretary Larry Summers and co-authors suggests that high household borrowing costs may even help explain what remains somewhat of a mystery: Why, despite With a strong job market and moderate inflation, consumer mood remains gloomy?

Small businesses also use many credit cards. According to a recent survey, 56% of them regularly use credit cards to spend. Credit lines are also tied to short-term interest rates. Credit restrictions on small businesses could lead to less job growth. 

Businesses with fewer than 100 employees account for about one-third of private employment, while research shows that growing small businesses are the driving force behind job growth in the United States.

Meanwhile, long-term interest rates have not increased nearly as much as before the pandemic as the benchmark interest rate targeted by the Fed. The yield on the 10-year Treasury note is around 4.3%. While higher than before the pandemic, this number is not historically very high and is significantly lower than the 5% level last fall.

In February 2005, then-Fed Chairman Alan Greenspan declared that low long-term interest rates relative to short-term interest rates were a “conundrum.” At the time, long-term interest rates were about the same as they are today, with the 10-year yield around 4.2%. But the Fed's target for its benchmark interest rate is much lower, at 2.5%.

Long-term interest rates are relatively low partly because investors expect the Fed will lower interest rates at some point. It may also reflect investors' confidence that the central bank will be steadfast in its efforts to control inflation, according to Duke University economist Anna Cieslak.

Investors think the Fed will be able to control inflation and avoid letting the economy fall into recession. This is reflected in low corporate bond yields and soaring stock markets. The difference/spread between Treasury bond and corporate bond interest rates is narrowing. Stocks also hit new highs and the S&P 500 is up more than 30% from a year ago.

Meanwhile, mortgage rates, which are important to many households, remain much higher than before the pandemic, and the spread between them and Treasury rates is widening. High mortgage rates have made it impossible for many people to buy a home.

As a result, large companies that can tap into the public markets enjoy easier borrowing conditions than many small businesses and households, while the growing stock assets of investors are bringing a favorable wind for the economy. 

Overall US financial conditions are becoming less and less tight. The Fed's own index, based on a range of measures including overnight interest rates, bond yields, mortgage rates, home prices and stocks, showed conditions in January were at their loosest since January. August 2022.

“Ultimately, the thing policymakers can most directly control is short-term interest rates,” said Johns Hopkins economist Jonathan Wright.

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