The Fed has more to do than market recognizes

The Marriner S. Eccles Federal Reserve building in Washington, D.C., on Feb. 19. Samuel Corum/Bloomberg

PRINCETON, N.J. — Investors are increasingly betting that the Federal Reserve will have to raise interest rates sooner than previously expected to keep inflation in check. A few months ago, futures prices implied that “liftoff” from the current near-zero level wouldn’t occur until 2023 or later; now they suggest it’ll happen near the middle of next year.

There hasn’t, however, been a similar shift in how high investors expect interest rates to go. Markets still see a peak in this business cycle of less than 2%. I think there’s a good chance they’re mistaken.

Let’s start with the Fed’s own perspective. As of September, officials estimated that the “neutral” federal funds rate — the rate consistent with the central bank’s 2% inflation target — would be between 2% and 3%, already higher than market expectations.

But under its new monetary policy framework, the Fed intends to allow inflation to rise above 2% to make up for previous downside misses. If, say, inflation went to 3%, the neutral rate would be 3% to 4% — and the Fed would eventually have to raise interest rates significantly higher than that to make monetary policy sufficiently tight to bring inflation back down to its long-term target.

History also implies a considerably higher peak in interest rates. The lowest peak on record — between 2.25% and 2.5% — occurred during the last expansion, which was very different from the current one. First, the pandemic cut the last business cycle short, which was one reason why the Fed had no inflation problem to combat.

Second, the economy faced significant headwinds — including collapsed home prices and restrictive fiscal policy — that don’t exist this time around. Finally, financial conditions were a lot less accommodative than they are now: The stock market has been hitting record highs, bond yields are unusually low and credit spreads are very narrow.

So how high will rates need to go? This depends on how easily higher rates will tighten financial conditions and cool off the economy. So far, there’s little sign they’ll have much effect. Even as rising prices and wages have brought the expected liftoff date closer, stocks have kept going up and bond yields have increased only modestly.

Homeowners and corporations are largely insulated from higher short-term rates: Most residential mortgages have fixed rates, and companies lock in much of their funding via longer-term borrowing. All this suggests that to actually rein in financial conditions and economic activity, the Fed will have to raise short-term rates by considerably more than what’s currently anticipated.

The last time the central bank faced unresponsive markets, between 2004 and 2006, it had to increase rates at 17 consecutive policy-making meetings, to 5.25% from 1%. That episode may be a better template than the last business cycle.

On the bright side, a higher peak rate will leave the Fed with more room to ease when the next recession hits. For markets, though, getting to that higher peak will probably come as an unpleasant surprise first.

Bill Dudley, a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics, is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018 and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs. © 2021 Bloomberg Opinion.

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