A major Federal Reserve official briefly spooked the SPX stock,
and TMUBMUSD10Y bond,
markets on Thursday by warning that the central bank may need to raise interest rates much more than the market expected. But the official left out some important information that undermines his argument and suggests that the market probably had it right in the first place.
Reading History: This is the chart rocking US financial markets on Thursday
“ Tighter monetary policy is no longer just about raising interest rates. it’s also about the Fed’s balance sheet reduction and future guidance.“
First some background and then I’ll explain what the Fed official did wrong.
St. Louis Fed President James Bullard said in a speech on Thursday that the federal funds rate of FF00,
— now in a range of 3.75% to 4% — would probably have to rise much more to contain inflation. Without predicting a specific number, Bullard included a chart that said the Fed Funds rate would have to rise between 5% and 7% in order to be “sufficiently restrictive.”
Read now: Fed’s Bullard says policy rate in 5%-7% range may be needed to lower inflation
Most observers expected the Fed’s so-called terminal rate to be around 4.75% to 5.5%, so Bullard’s warning came as a bit of a shock.
Bullard based his estimates on the Taylor rule, which is a commonly (though not universally) accepted rule of thumb that shows how high the federal funds rate would need to be to create enough unemployment to reduce inflation to the long-run target . 2% level.
There are several variations of the Taylor rule, the most extreme of which would require a federal funds rate of 7% (according to Bullard’s chart) if inflation proved more persistent than current projections.
A 7% funds rate would likely push stock and bond prices much lower, and that was a big downside to markets that rallied last week on the belief that inflation was starting to ease.
Vivien Lou Chen: Financial markets are once again operating on a “peak inflation” narrative. Here’s why it’s complicated.
What Bullard said did not contradict what Fed Chairman Jerome Powell had said in his last press conference: that the Fed should raise interest rates higher and for longer. Bullard’s chart simply put a very dramatic number on what Powell had only hinted at.
What Bullard ignored in his analysis was that monetary policy tightening is no longer just about raising interest rates. It’s also about reducing the Fed’s balance sheet and forward guidance, both of which also effectively tighten monetary policy. In other words, a 4% federal funds rate today cannot be directly compared to a 4% federal funds rate in the Paul Volcker era, which is what the Taylor rule does and what the Bullard chart does.
A recent paper by economists at the Federal Reserve Banks of San Francisco and Kansas City argues that, after adding in the economic and financial impact of forward guidance and quantitative tightening, the interest rate target (as of September 30) was 3%-3.25% . equivalent in monetary tightness to a ‘proxy feed funds’ of around 5.25%. After a 75 basis point increase on November 2nd, I estimate the ratio is now around 6%.
That’s just 100 basis points from Bullard’s doomsday scenario. But the market was already pricing in 125 basis points of tightening!
And this is the most extreme price. Plug in other forecasts of inflation and unemployment rates and you get lower numbers than the Taylor rule. The median is around 3.75%, meaning that the nominal rate on feeder funds is already in a “fairly tight” range. The “proxy fund rate”, which contributes to forward guidance and QT monetary policy, is already in the middle of the range.
That means Fed policy may already be “tight enough” to bring inflation down to 2%, which is certainly not a message Bullard and his colleagues want the markets to hear. If the markets believed it, then the guidance outlook would be weaker and the interest rate would fall and the Fed would have to raise rates more.
We know why Bullard said what he said: He’s in the business of forward guidance, trying to get the financial markets to do the Fed’s job for it. If equity and bond markets began to expect a “pivot” to slower rate hikes or even rate cuts next year, it would undermine what the Fed is trying to accomplish this year.
Fed officials always intend to push the markets. Right now, they’re doing this by emphasizing how high interest rates can go and how long the Fed can keep them there. The more markets believe a 7% funds rate is likely the less likely the Fed will need to raise rates to even 5.50%.
It’s the Fed’s job to bluff and it’s the market’s job to call its bluff.
Rex Nutting is a MarketWatch columnist who has been reporting on the economy and the Fed for more than 25 years.
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