Whenever the Federal Reserve begins to tighten financial conditions, markets try to guess how far the central bank will go.
Indeed, now in an era where it provides its future policy estimates in a framework known as “the dots,” the Fed yes is providing indications on where the fed funds rate will land. For 2023 and 2024, the median rate is seen by FOMC members who set policies at 3.375%; 4.375% is expected in 2023.
But, of all the comments that have been made, the most important is being made every day on the bond market. The fact that the 10-year stock produces TMUBMUSD10Y,
trading up to, and currently below, 3% is a clear vote of confidence that inflation does not get out of hand. With the federal funds rate currently in the high range of 2.5% and with inflation running at 9.1% on the CPI, only a fool would buy and hold 10-year bonds with a yield of 3% or less if you thought inflation will last. Clearly, the bond market doesn’t think so.
However, that doesn’t make it perfectly clear what the bond market thinks.
Fighting in the mud for the recession
Chris Waller and a co-author, and Larry Summers and his co-authors, are squabbling a bit in the mud over whether the Fed can lower inflation without having a recession, or at least a significant increase in the unemployment rate.
Waller, a Federal Reserve Board governor, would clearly argue that the Fed can raise rates and not necessarily plunge the economy into a recession. This possibility would make the Fed’s rate hike policies a little easier for the public and policymakers to digest. Summers and his co-authors hold the opposite view that in order to reduce the rate of inflation, the unemployment rate must rise.
It is unclear whether the bond market has a position on these issues. History clearly shows that inflation only fell from very high levels after the recessions. These recessions generally came after the Federal Reserve significantly hiked rates. History has not yet produced a situation where interest rates rise and inflation falls significantly without a recession. That doesn’t mean Waller won’t be the best in this debate. It just means that he doesn’t have a history like him herding him.
“Real” Federal Funds Rate: A Red Head?
Historically, it is true that the Fed has always had the highest fed funds rate of inflation whenever a recession has started. However, this has also been true in the recessions that have started and ended and have failed to bring the rate of inflation back to a level of price stability.
Currently, with the inflation rate so high and the federal funds rates so low, I don’t know anyone who thinks we’ll be able to get that rate above the inflation rate or who would actually approve of it. However, bond market behavior suggests that the inflation rate is about to go down and there may be a point along the way where the federal funds rate and the inflation rate may have a more normal historical relationship. But will we get to that point by raising the federal funds rate or leading a recession first?
One of the things I find most interesting is that few people in the Federal Reserve are willing to talk about it. In his latest press conference, Fed Chairman Jerome Powell reported that the federal funds rate has finally reached the neutral position. This is a rather surprising statement. How is a 2.5% rate neutral when the CPI is at 9.1%? I can’t start wrapping my mind on this.
The Fed may continue to think that much of the inflation will drain itself. Recall that the entire tightening episode was delayed by the Fed saying inflation will be transient. It strikes me that the Fed still has that belief, but is worried about repeating that phrase because it already had to eat those words once in public and they didn’t taste good.
However, CL.1 oil prices,
they eased and there was a solid turnaround in commodity prices. The price indicator in the manufacturing ISM fell sharply in July. And there are reasons to think that some of the inflation is actually quite temporary and will more or less run on its own. The supply chain is under repair. But wage inflation has risen. Not all of the toothpaste will go back into the tube by itself; the Fed will have to scrape there using monetary policy. The Fed does not want to engage in a discussion on this subject until some good news is on the table.
The bond market impresses me, departed, because it gave its best with the notion of inflation control at an early stage. I wonder how high the federal funds rate will have to go up before it starts producing some results. The bond market suggests that it won’t have to climb very high. After that, you are on your own.
I can appreciate the argument Waller is trying to make, but if I had to side with Summers, who is looking for a recession. This is because recessions stop inflation. And I think this is what the bond market knows and why its yield curve has been reversed.
Robert Brusca is FAO Economics chief economist.