Fed's Kaplan Makes A Stark Admission: Equilibrium Rate May Be As Low As 0.25%

As we have hammered away at for years, "the math doesn't work", and it appears The Fed just admitted it.

In a stunning admission that i) US economic potential is lower than consensus assumes and ii) that the Fed is finally considering the gargantuan US debt load in its interest rate calculations, moments ago the Fed's Kaplan said something very surprising:


Another way of saying this is that r-star, or the equilibrium real interest rate of the US (calculated as the neutral rate less the Fed's 2.0% inflation target), is a paltry 0.25%.

What Kaplan effectively said, is that with slow secular economic growth and 'fast' debt growth, there's only so much higher-rate pain America can take before something snaps and as that debt load soars and economic growth slumbers so the long-term real 'equilibrium' interest rate is tamped down. It also would explain why the curve has collapsed as rapidly as it did after the Wednesday FOMC meeting, a move which was a clear collective scream of "policy error" from the market.

This should not come as a surprise. As we showed back in December 2015, in "The Blindingly Simple Reason Why The Fed Is About To Engage In Policy Error", when calculating r-star, for a country with total debt to GDP of 350%...

... The equilbirium real rate is around 0.4-0.6% at most, certainly below 1%, and as low as 0.30%.


Furthermore, as Deutsche Bank's Dominic Konstam said almost two years ago, "One might argue for low “implied” equilibrium short rates via debt ratios. For example, if nominal growth is 3 percent and the debt GDP ratio is 300 percent, the implied equilibrium nominal rates is around 1 percent. This is because at 1% rates, 100% of GDP growth is necessary to service interest costs.

In this case, real growth would slow in response to rate hikes because productivity would stay weak at full employment and companies would be profit/price constrained around paying higher wages.


Moreover, nominal growth would then slow even more than real growth does because inflation would fall to 1 percent or below.

To be sure, the Fed hinted as much two days ago, when on Wednesday it lowered its longer-run federal funds rate to 2.75% from 3.00%. Another hint came last week from the BOC which, together with Bill Dudley, hinted it was willing to considering changing its mandate, i.e. lowering the inflation target, thereby unlocking some potential upside to the Real Interest Rate.

In the meantime, however, the mere fact that another Fed president is once again hinting that r-star is far lower than consensus, is an indication that the central bank is very limited in how much more tightening it can pull out this cycle. The simple math is that if Kaplan is right, the Fed has at most 3 more hikes left before it prompts yield curve inversion and another recession.

Expect to hear much more on this now that the r-star genie is out of the bottle. Finally the other consideration is that with the Fed once again talking about cutting the neutral rate, is means that not only is tightening approaching its end, but that the Fed may soon be forced to ease, by either cutting rates or QE.

Which also explains the second part of Kaplan's statement: that the Fed is not as "accomodative as people think." That is basically the Dallas Fed president jawboning risk assets lower, an implied warning that the market is not appreciating how close to capacity the economy currently is. Of course, the question why stocks aren't dropping is best left to the ECB and BOJ...

Then again, maybe this time the market will notice, as LT yields are finally starting to move.


Baron von Bud Fri, 09/22/2017 - 14:47 Permalink

To diminish the US debt over time, inflation must grow faster than debt. But, doing that will cause the dollar to decline. If rates go up then the debt soars and the dollar falls. Looks like we're screwed either way. Got gold?

Baron von Bud DerdyBulls Fri, 09/22/2017 - 15:04 Permalink

Gold can rise or fall but, like any commodity, it can't long stay under the cost of production [$1100] or they stop mining it. Will gold fall in the next recession? What do governments throughout time always do in severe or protracted recessions? They spend money. If they don't, then they experience social disruption. Considering that 50% of Americans haven't got $500, what will they do? There's your answer.

In reply to by DerdyBulls

crazybob369 Fri, 09/22/2017 - 15:12 Permalink

Just for chuckles, and because I don’t have much of a life, I decided to do some simple spreadsheet calculations on the .gov debt in a 5% world. Assuming no additional increases in any type of spending (sure!), here are the grim results: By year 10, the debt will be almost 50 trillion and the interest will eat up the entire revenue collected by treasury. By year 20, the debt would be over 150 trillion and the interest would eat up almost 3 times the amount of revenue collected. By year 25, 240 trillion debt, 12 trillion in interest. Go ahead Janet, raise rates. I dare you. I double dare you. I 12 trillion dare you.

JBPeebles crazybob369 Fri, 09/22/2017 - 16:03 Permalink

Minused you because interest on the debt is now about $250 billion/yr.. Start your analysis with good data or it's GIGO'ed.If the debt grows by 150% in 10 years, the interest will not all be charged at your hypothetical rate of 5%. Older debt will be paid off at the rates specified at the time of issuance. New debt, though, typically needs to be sold at higher rates the more that's issued, under the prudent principle that the borrower's ability to repay decreases as their debt load increases. To some degree this is irrespective of interest rates offered and more a question of whether access to further credit--by which they can cover their interest obligations-- will be limited in the future.To get to 5% would mean that the price of government securities would go down in the secondary market but the interest rate adjustments would not change the interest rate paid on older debt as the note rate never changes (baring default)  whatever the pricing does. Although the yield would go up for buyers of new securities, in the secondary market where the older stuff is sold the value of existing debt would fall to catch up with higher yields offered in the newer debt.Corporations would struggle at the new interest rate because of malaise in the general economy. Add to whatever the government pays--the so-called "risk-free rate"--whatever premium (or price increase) that the market associates with a private issuer who can't just print the money up. Like we saw in '07-08 it may be possible that some yields on solid blue chip corporate debt go below the rate offered by the government--the inverse of crowding out, which usually pushes rates higher on non-government debt. This implies that the government will be issuing better yielding debt at lower prices in the near future. Why get punished for holding something riskier than the Treasuries?Corporate credit has been abused to buyback stock and trigger Executive pay packages based on quarterly performance. The e.p.s. model makes earnings look better but this is due to the smaller number of outstanding shares. Look at gross corporate earnings, which have fallen 7% for the S&P this year. This borrowing creates a huge hole in the ability of corporations to borrow in the longer-term when rates normalize (go up.) The bought back stock doesn't go into new facctories, or worker training. In this sense the easy credit discourages healthy business investment into the economy and is obstructing a full recovery.Remember as bad as higher rates might be for borrowers, they constrict the ability to get credit and encourage better fiscal discipline among borrowers. Higher rates also feed savers who can then invest or spend more because their savings yield more.While higher rates aren't expansionary, the financialization of the economy means so much of the numbers derive from easy access to credit. Prices would crater to adjust to the true price of debt and equities, which is a necessary and much-delayed built-in relief valve available in a real free market system--the dreaded yet needed creative destruction. 

In reply to by crazybob369

crazybob369 JBPeebles Fri, 09/22/2017 - 16:08 Permalink

Yo, dude! I thought I didn't have life, but man...! It was not my  intent to do some in-depth, accurate-to-the-penny analysis of the national debt. It was simply to point out the ridiculousness that the debt has become and the cluelessness of those in charge. The scenario would actually be much worse because it doesn't include the trillions in unfunded liabilities that will be coming due. The system would collapse long before the numbers became that large. The interest rate hikes would simply exacerbate the problem. 

In reply to by JBPeebles

Catullus Fri, 09/22/2017 - 15:56 Permalink

It's like we never grew ever prior to 2007 with interest rates in the stratosphere of 5%.

It's also a tacit admission that they just papered over a problem with more debt and created a larger problem at a lower interest rate.