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Whenever the Federal Reserve starts to tighten financial conditions, markets try to guess how far the central bank will go.
In fact, now in an era when it is providing its estimates of future policy in a framework known as “the dots,” the Fed itself is providing guidance on where the fed funds rate will land. For 2023 and 2024, the median rate is seen by policy-setting FOMC members at 3.375%; one expects 4.375% in 2023.
A number of former Federal Reserve officials have also weighed in on what they think policy should do. Alan Blinder, former vice chair of the Fed, has cautioned to go slow. Lawrence Lindsey, a former Fed governor, has referred to the practice of getting the fed funds rate above the inflation rate as something that worked in the past. Judy Shelton, an economist once proposed for Federal Reserve board membership, has derided the Fed for not raising the rate to the inflation rate as it used to do.
But, of all the comments that have been made, the most important one is being made every day in the bond market. The fact that the 10-year note yield
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is trading down to, and currently below, the 3% mark is a clear vote of confidence that inflation won’t get out of hand. With the fed funds rate at a top range of 2.5% currently and with inflation running at 9.1% on the Consumer Price Index, only a fool would buy and hold 10-year notes yielding 3% or less if they thought inflation was going to last. Clearly, the bond market does not think that.
However, that doesn’t make it perfectly clear what the bond market does think.
Mud fight over recession
Chris Waller and a co-author, and Larry Summers and his co-authors, are having a bit of a mud fight over the concept of whether the Fed can bring inflation down without having a recession, or at least a significant rise in the rate of unemployment.
Waller, a governor on the Federal Reserve Board, clearly would like to make the case that the Fed can raise rates and not necessarily plunge the economy into a recession. That possibility would make the Fed’s rate-hiking policies just a little bit easier to swallow for the public and politically. Summers and his co-authors take the opposite point of view that to reduce the inflation rate, the unemployment rate has to go up.
It’s not clear that the bond market has a position on these issues. History clearly shows that inflation has only come down from very high levels after recessions. Those recessions generally have come after the Federal Reserve has raised rates significantly. History has yet to produce a situation where interest rates rise and inflation falls significantly without a recession. That doesn’t mean Waller won’t be top gun in this debate. It just means that he doesn’t have history as his wingman.
‘Real’ fed funds rate — a red herring?
Historically, it’s true that the Fed has always had the fed funds rate higher than the inflation rate whenever a recession has started. However, this was true even in the recessions that were started and concluded and failed reduce the inflation rate back down to a level of price stability.
Currently with the inflation rate so high and the fed funds rates so low, I don’t really know of anyone who thinks that we are going to get that rate up above the inflation rate or who actually would endorse it. However, the behavior of the bond market suggests that the inflation rate is going to be coming down, and there may be a point down the road where the fed funds rate and the inflation rate can have a more normal historic relationship. But are we going to get to that point by raising the fed funds rate or by running a recession first?
One of the things that I find most interesting is that few people in the Federal Reserve are willing to even talk about this. At his last press conference, Fed Chair Jerome Powell referred to the fed funds rate as finally getting up to the position of being neutral. This is quite a stunning statement. In what sense is a 2.5% rate neutral when CPI is running at 9.1%? I can’t begin to wrap my mind around that.
It may be that the Fed continues to think that a lot of the inflation is going to unwind by itself. Remember the whole tightening episode was delayed by the Fed saying that inflation is going to be transitory. It strikes me that the Fed still has that belief but it’s worried about repeating that phrase because it already had to eat those words once in public and they didn’t taste very good.
However, oil prices
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have softened and there has been a solid turnaround in commodity prices. The price gauge in the manufacturing ISM fell sharply in July. And there are grounds for thinking that some of the inflation actually is quite temporary and will turn around more or less on its own. The supply chain is being repaired. But wage inflation has picked up. Not all the toothpaste will go back into the tube on its own; the Fed is going to have to scrape it there using monetary policy. The Fed does not want to get engaged in a discussion on this subject until some good news is on the table.
The bond market impresses me, party because it has thrown its lot in with the notion of inflation control at an early stage. I wonder how high the fed funds rate will have to go before it starts to produce some results. The bond market suggests it will not have to move very high at all. After that, you are on your own.
I can appreciate the argument that Waller it trying to make, but if I had to take sides it would be with Summers, who is looking for a recession. This is because recessions stop inflation. And I think that is what the bond market knows and why its yield curve has been inverted.
Robert Brusca is chief economist of FAO Economics.
