But the financial markets’ response this month suggests a lack of confidence that the current expected terminal rate — the level at which the Fed finally stops raising rates — is high enough to finish the job. Even if the economic data cooperates over the next two months, there will likely be at least one more upward push in the likely terminal rate before investors can breathe a sigh of relief.
This raises the question of how the Fed views the terminal rate. At its September monetary policy meeting, the Fed projected that the target federal funds rate would reach 4.6% – a range between 4.50% and 4.75% – in 2023. (The so-called federal funds rate federal funds is currently 3.25%.) – September’s higher-than-expected Consumer Price Index report has led some Fed officials to talk of hitting that range by the end of September. this year, what the markets have currently forecast: a 0.75% increase next week, then either a 0.50% increase or a 0.75% increase at the December meeting. Markets are signaling that they expect another 0.25% increase in early 2023, bringing the terminal rate to a range of 4.75% and 5%.
But if you’re the Fed, the market’s response to those expectations has been disheartening. Through Monday, the S&P 500 is up 6% on the month (although it’s still down 20% on the year, so by itself that shouldn’t be a problem for the Fed). More worrying was the recovery in equilibrium rates, which indicate the level of future inflation expected by the bond market.
By the end of September, break-even rates had fallen to levels seen in the 2010s, suggesting that bond market inflation expectations were in line with Fed targets. This is probably no longer the case. Through Monday, two-year break-even rates rose 0.93% on the month, five-year breakevens rose 0.54% and 10-year breakevens rose 0. .43% – and all are now at higher levels than we have seen at any time in the 2010s.
The bond market expects the consumer price index to increase by an average of 2.65% per year over the next five years, but this is going in the wrong direction and exceeds the inflation target of 2% from the Fed.
Market-based price signals should be given more weight at a time when the “hard data” does not yet provide the Fed with the right indicators to slow the pace of tightening. Core inflation continues to be well above target, and while there are signs that inflation is likely to ease in the coming months, the Fed would likely want at least three months of data to be reassured. At the same time, neither the labor market nor financial markets are showing enough signs of slowing, with employment remaining strong and markets looking healthier than a month ago.
The Fed’s evolutionary approach has been like cooking a bag of popcorn in the microwave. Like the conduct of monetary policy, it is a data-driven process, as anyone who has ever burned popcorn despite carefully following the instructions on the bag can attest. During the first two minutes, the bag heats up and expands and the kernels begin to pop with increasing intensity. That’s more or less what we’ve seen from the Fed since March as it aggressively hiked rates from 0% at a time of high inflation. It’s only when the snapping slows down that you need to be more careful. You can’t see inside the bag, so watch for other signs that the process is complete (or that you’ve gone too far), such as no popping noises or a burning smell. This is the phase the Fed is entering now.
Conclusive data on inflation or labor markets showing that the Fed has done its job won’t arrive until the first quarter of 2023, at the earliest. In the meantime, market signals should carry more weight and, unfortunately, the inflationary reaction of markets in October to the Fed’s perceived tightening path suggests that we have not yet priced in enough interest rate hikes. . We should be ready for the Fed terminal rate to end up north of 5%.
More other writers at Bloomberg Opinion:
How the front loading rate increases the risk of instability: Mohamed El-Erian
Will Jerome Powell be like Volcker or Burns? : Bill Dudley
The next Fed crisis is brewing in Treasuries: Robert Burgess
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Conor Sen is a Bloomberg Opinion columnist. He is the founder of Peachtree Creek Investments and may have an interest in the areas he writes about.
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