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Over-Reacting . . . as usual

03/08/2021

Wall Street is over-reacting to the recent spike in long-term interest rates, but I’m not.

In introductory economics, students are taught that the Fed controls short-term rates but not long-term rates, and that was true . . . until quantitative easing (QE), which followed the Great Recession or Global Financial Crisis, as I prefer to call it.  Normally, long-term rates should be higher than short-term rates, because there is greater risk with long maturities, due to inflation or credit risk.  Short-term rates and long-term rates are related but can move independently, in opposite directions.

Traditionally, increasing long term rates, relative to short-term rates, indicate either a growing economy or an outbreak of inflation.  Sometimes, short-term rates will be higher than long-term rates, which is called an “inverted yield curve.”  This is always a worrisome economic indicator.  In 2011, the Chair of the Fed was Ben Bernanke, often called the “father of QE” and he faced an inverted yield curve.  In response, he launched “operation-twist” which drove down short-term rates and drove up long-term rates, by buying short-term bonds in the Fed’s portfolio and selling long-term bonds.  It was a great success, cementing control over long-term interest rates by the Fed.

While Wall Street is over-reacting to the recent spike in long-term rates, the Fed is already hinting at a reverse operation twist, where the Fed will sell short-term bonds and replace them with long-term bonds.  Bottom Line:  the Fed has both the tools and the resolve to control long-term rates.  Don’t over-react!

On the other hand, Washington is giddy and over-reacting to the latest jobs report.  Expecting 210 thousand new jobs, we found the economy created 370 thousand jobs in February.  Plus, we learned there were 117 thousand more jobs created in January than earlier reported.  The biggest increase was in the hospitality and travel sector, which was so severely hurt by the pandemic.  Job growth would have been even better without the terrible winter storms, causing a loss of 61 thousand jobs in the construction.  The consensus is that the economy has hit bottom.  We should not over-react to this good news.  With 9.5 million out-of-work, it will take over two years to recover, assuming 400 thousand new jobs each month.  Even worse, labor economists worry about “structural unemployment” which occurs when jobs relocate or change more than the workforce.

As we recover, workforce development will become increasingly critical.  I was hoping the new America Rescue Plan would speak to this problem, but it doesn’t.  Allowing the government to run workforce development would be a disaster, but serious preferential tax treatment for companies developing their own workforce would eliminate this structural unemployment.  That is good corporate welfare!  Don’t over-react!

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