Vanguard experts put U.S. rates in perspective


Vanguard Perspectives® Gemma Wright-Casparius: Roger, what’s Vanguard’s outlook for long-term interest rates in 2017?

Roger Aliaga-Díaz: Yes, this is an important question, given the rise in rates we saw—in long-term rates we saw since the U.S. election. There is some concern about that increase in rates. Our view is that at the current level of rates, say 2¼% to 2½%, is what we call the fair-value level in the sense that rates are at the level that match our view on the economy and inflation and the [Federal Reserve] going forward. Economic growth, inflation are key ingredients on the level of long-term rates, and our view is that growth is going to remain subdued. Not necessarily a pessimistic view, but a 2 to 2½% growth. The Fed is very gradually increasing rates over the next three to four, even five, years. And because of that, it’s hard to justify from a point of view of economic fundamentals, long-term rates that are much higher than 2.5% right now. So that basically gives us confidence that the current range of rates is what we call fair-value rates.

Gemma Wright-Casparius: Right. So what we saw in the markets late last year was a rise in inflation expectations, not only in the United States but in Europe and around the world. And a lot of that had to do with the commodity reflation story. The U.S. dollar’s relatively stability last year helped alleviate some downside pressure in U.S. inflation. So the U.S. rate portfolio management team had been looking for a short-term rise in inflation in the United States. And we saw inflation expectations respond after the election appropriately to the risk of new fiscal stimulus. But it’s driven more by the commodity reflation story and the fact that the dollar, which was relatively stable in 2016 and holding back the inflation metrics in 2015, had basically reversed. And so, on a short-term basis, we’re seeing inflation trend toward the Fed’s objective and target. And I think we’re somewhat optimistic that there, as you say, could be potentially upside risk to growth. There could be upside risk to inflation in 2017. But we actually are somewhat cautious for two reasons: One, the long-term structural trends of demographics, globalization, technology will hold down inflation. But the second is also the Fed’s reaction to a slightly faster pace of inflation. Andrew, what would you think the Fed, and how would you think the Fed, would respond to an upside surprise to inflation, above their forecast this year?

Andrew Patterson: So I think that’s one of the concerns we have heading into 2017, really, is the Fed’s reaction function and just how quickly do they raise rates. We believe, given economic fundamentals, which despite a lot of discussion around policy and broad changes, we don’t believe they’ve changed significantly from where we stood earlier in 2016. So we think a gradual pace is still appropriate. If the Fed were to see an uptick in inflation, they could very well raise rates faster than expected. If it was an environment where they were raising rates faster than expected to combat inflation, we don’t necessarily see that as a policy error. If they were to raise rates faster than expected to try to get out in front of perceived strengthening and growth, perceived strengthening and inflation, we think that could have some ripple effects to the broader economy. In our view, when the Fed’s projections came out in December, they believed that three rate increases in 2017 would be most appropriate. We’d be comfortable with that. We could also make a case for two moves. Again, we think that it’s appropriate that they continue their—not tightening—but very gradual, data-dependent removal of extraordinarily easy monetary policy.

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