The Tell: The Fed won’t raise rates for years. Here’s why that might be a bad thing

The Fed will keep policy extremely easy for some time to come, which will ultimately culminate in an inflation spike in the middle of the decade, according to a report from BCA Research. Read More...

Has the Federal Reserve painted itself into a corner?

By keeping interest rates so low for so long and buying up so many bonds to boost the economy, the central bank has caused asset prices to spike, and encouraged governments and corporations to pile on more debt, critics say.

Now, many fear that any attempt to tighten monetary policy will rattle markets and the economy.

In order to avoid that, the Fed will keep policy extremely easy for some time to come, which will ultimately culminate in an inflation spike in the middle of the decade, according to a report out Friday from BCA Research.

As the report notes, the Fed has steadily pared its estimate of the neutral rate of interest, which is the interest rate that would prevail in an economy with stable inflation and full employment. Most Fed officials expect to make no interest rate increases through 2023, and for the neutral rate to be only 2.5% over the long run, down significantly from the past.

There are lots of reasons the long-term neutral rate has declined over time, including an aging population, an economy that’s increasingly services-heavy and manufacturing and capital-light, and slower growth overall.

But the BCA analysts expect things to change. The neutral rate of interest is determined, in large part, by the supply and demand for savings. And baby boomers are retiring, changing from savers to spenders—just as trillions of dollars more of government spending hits the economy.

If the Fed were to start raising interest rates in the next few years, “what had previously been a virtuous fiscal circle would become a vicious one,” the BCA team wrote. “Needless to say, governments would resist such an outcome. Faced with the prospect of having to reallocate tax revenue from social programs to bondholders, politicians would put political pressure on central banks to refrain from raising rates. Central banks would probably oblige, at least initially. By keeping interest rates below their equilibrium level, central banks could engineer higher inflation.”

It’s worth noting that the question of higher inflation isn’t semantic: investors have gotten a small taste of what a regime change like that could mean over the past few weeks as climbing bond yields TMUBMUSD10Y, 1.617% have sparked a stock selloff .

There are pluses and minuses to a higher-rate economy, BCA writes. Rising inflation means real rates would fall, which would help borrowers. BCA imagines an activist central bank responding to such a dynamic: “Once enough debt had been inflated away, central banks could bring interest rates to their equilibrium level,” the analysts write.

“In the end, bondholders would suffer while borrowers would prosper.”

For now, that’s on the horizon, they conclude. “The Goldilocks environment for risk assets – where growth is strong, inflation is contained, and monetary policy is accommodative – will last another two years. Investors operating on a 12-month horizon should continue to favor stocks over bonds.”