A day after a Federal Reserve official’s market-moving admission that interest rates may need to go as high as 7%, analysts have come to an even more surprising conclusion: That 7% still won’t be high enough to win the battle against inflation .
In a presentation made Thursday in Louisville, Kentucky, St. Louis Federal Reserve President James Bullard estimated that from 5% to 7% the target for the federal funds rate is what is needed to move borrowing costs into an area sufficient to slow economic growth and cause inflation to fall significantly. As a result of these forecasts, US stocks suffered for the first time on Thursday back to back losses for two weeks, ICE US Dollar Index
and Government bond yields jumpedand many parts of the Treasury curve flashed worrisome signs about the economic outlook.
Investors, however, took Bullard’s opinion with a grain of salt. The bond market steadied, along with the dollar, early Friday after comments from a second Fed official, Susan Collins, sparked an afternoon selloff in government debt. Meanwhile, optimism returned to stocks in all three major indexes
finishing higher on Friday. Behind the scenes, some economists applauded Bullard for his honesty, while other analysts said his estimates were not as shocking as investors and traders believed. One of the most underappreciated risks in financial markets is that inflation fails to return to 2 percent quickly enough to ease the need for more aggressive moves by the Fed, traders, money managers and economists told MarketWatch.
Stifel, Nicolaus & Co. economists Lindsay Piegza and Lauren Henderson said they thought even a 7 percent federal funds rate could be an “understatement” of how high the Fed’s benchmark rate should likely go. Calculations show that there is a possible need “for a federal funds rate potentially 100-200bps higher than [Bullard’s] proposed upper limit,” they wrote in a note. In other words, a federal funds rate that reaches between 8% and 9%, versus the current range between 3.75% and 4%.
“The recent improvement in inflationary pressures, reversing from peak levels, appears to have somewhat blinded many investors to the need for the Fed to continue aggressively on the path to higher rates,” they said. “While 7.7% annual profit in [consumer price index] is an improvement from the 8.2% annual pace previously reported, hardly something to celebrate or a clear signal for the Fed to move to easier policy with a target range of 2% still a distant achievement.”
Stifel economists also said Bullard was counting on a historically low neutral interest rate, or theoretical level in which the Fed’s policies neither stimulate nor constrain economic growth, as part of its assumptions.
Piegza and Henderson are not alone. In an unsigned note, UniCredit researchers said that while “7% was downright shocking” for financial market players to hear, the idea of a federal funds rate that ends up being much higher than most people expect “is not is especially new’.
As of Friday, fed funds traders mostly expect the Federal Reserve’s main interest 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 percentage of fed funds 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 missed the impact of the Fed quantitative tightening process from his percentage scores.
After taking the QT process into account, the “inner range” of potential fed funds rate outcomes is “likely closer” to 4.5%-4.75% to 6.5%-6.75%, said Mizuho Securities economists Alex Pele and Stephen Ricciuto. The “full range” of plausible outcomes is even wider, however, and could range from 3.25% to 3.5% “at the ultra-dovish end, in which case the Fed is already overtightening” and 8.25% -8. 5% “from the ultra-hawkish end, where the Fed is only halfway there.”
Chris Lowe, chief economist at FHN Financial in New York, called Bullard’s presentation “wonderful” because “it’s the most honest attempt to move public expectations for fed funds into a reasonable range offered by any FOMC participant to date.” .
“Just keep in mind that he did everything he could to avoid shocking the market,” Lowe said of Bullard. “His zone ranges from dovish to reasonable, not dovish to hawkish. Our expectations are still managed. We can’t blame him for that.”