A day after a market-moving Federal Reserve official admitted that interest rates may need to go as high as 7%, analysts reached an even more surprising conclusion: that 7% is still not high enough to win the battle against inflation.
In a presentation Thursday in Louisville, Ky., St. Louis Fed President James Bullard estimated that a 5% to 7% target for the federal funds rate is what is needed to move borrowing costs into a range sufficient to slow economic growth and produce a significant reduction in inflation. In the wake of those estimates on Thursday, US stocks suffered their first consecutive losses in two weeks, the ICE US Dollar Index DXY,
and Treasury yields soared, and many parts of the Treasury curve showed worrisome signs about the economic outlook.
However, investors took issue with Bullard’s views. The bond market steadied, along with the dollar, early Friday until comments from a second Fed official, Susan Collins, sparked an afternoon selloff in government debt. Meanwhile, optimism returned to equities, with the three main DJIA indices,
finishing higher on Friday. Behind the scenes, some economists applauded Bullard for his candor, while other analysts said his estimates were not as shocking as investors and traders believed. One of the most underrated risks in financial markets is that inflation fails to fall to 2 percent quickly enough to mitigate the need for more aggressive moves by the Fed, traders, money managers and economists told MarketWatch.
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Stifel Nicolaus & Co. economists Lindsey Piegza and Lauren Henderson said they believe even a 7% federal funds rate may “understate” how high the Fed’s benchmark rate should go. Calculations show that there is a potential need “for a federal funds rate potentially 100-200 bps higher than [Bullard’s] upper barrier is proposed,” they wrote in a note. In other words, a federal funds rate ranging between 8% and 9%, versus the current range between 3.75% and 4%.
“The recent improvement in inflationary pressures turning from peak levels has seemingly somewhat blinded many investors to the need for the Fed to continue aggressively on a path toward higher interest rates,” they said. “While an annual gain of 7.7% in [consumer price index] is an improvement from the 8.2% annualized rate previously reported, not something to celebrate or a clear signal for the Fed to ease policy with a target range of 2% still a distant achievement.”
Stifel economists also said Bullard is relying on a historically low neutral rate, or theoretical level at which Fed policies neither stimulate nor constrain economic growth, as part of his assumptions.
Piegza and Henderson are not alone. In an unsigned note, UniCredit researchers said that while hearing “7% was a complete shock” to financial market players, the idea of a Fed-funds rate that ends up being much higher than most people expect “not particularly new”.
As of Friday, Fed-funds traders mostly expect the Fed’s key rate target to reach either between 4.75% and 5%, or between 5% and 5.25%, by the first half of next year. However, standard interpretations of the so-called Taylor rule estimate suggest that the Fed-funds rate should be around 10%, according to UniCredit researchers. The Taylor rule refers to the generally accepted rule of thumb used to determine where interest rates should be relative to the current state of the economy.
Some have openly questioned the estimates made by Bullard, a voting member of the Federal Open Market Committee this year, noting that the policymaker omitted the effects of the Fed’s quantitative-tightening process from his rate estimates.
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Once the QT process is factored in, the “inner range” of possible outcomes for the Fed-funds rate is likely closer” to 4.5%-4.75% to 6.5%-6.75%, the Fed said. Mizuho Securities economists Alex Pelle and Steven Ricchiuto; However, the “full range” of plausible outcomes is even wider and could be from 3.25%-3.5% “at the very optimistic end, so the Fed has already tightened too much” and 8.25%-8, 5% “at the ultra-hawkish end, so the Fed is only halfway done.”
Chris Low, chief economist at FHN Financial in New York, called Bullard’s presentation “excellent” because “it’s the most honest attempt to shift public expectations about terminal-fed funds into a reasonable range that any participant has offered to date to the FOMC”.
“Just keep in mind, he did everything to avoid shock in the market,” Low said of Bullard. “His band ranges from dove to reasonable, not dove to hawk. Our expectations are still met. We can’t blame him for that.”