Analysis | Fed Pullback? Not If It’s Watching the Bond Market Closely


After a widely expected fourth straight 0.75% interest-rate increase next week, there’s a growing view that the Federal Reserve will  step down to a 0.50% bump  at their December meeting. Even with inflation still going strong, there’s value in the Fed becoming more flexible as  rates rise to a level restrictive enough to rein in inflation and growth in coming months.

But the response from financial markets 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 month or two, there’s probably at least one more push higher in the probable terminal rate before investors can breathe a sigh of relief.

This raises the question of how the Fed is thinking about the terminal rate. At its September monetary policy meeting, the Fed’s projection was that the target federal funds rate would hit 4.6% — a range between 4.50% and 4.75% — in 2023. (The so-called fed funds rate is currently 3.25%.) The hotter-than-expected September consumer price index report has led some Fed officials to talk about getting to that range by the end of this year, which is what markets have currently priced in:  a 0.75% increase next week, and then either a 0.50% or 0.75% increase at the December meeting. Markets are signaling they expect one more 0.25% increase in early 2023, taking 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 discouraging. Through Monday, the S&P 500 is up 6% on the month (though it’s still down 20% for the year, so by itself that shouldn’t be an issue for the Fed). More concerning has been the recovery in breakeven rates, which indicate the level of future inflation expected by the bond market.

At the end of September, breakeven rates had fallen to levels seen in the 2010’s, suggesting the bond market’s inflation expectations were consistent with the Fed’s objectives. That’s arguably no longer the case. Through Monday, two-year breakeven rates are up 0.93% on the month, five-year breakevens are up 0.54%, and 10-year breakevens are up 0.43% — and all are  now at levels higher than we saw at any point in the 2010’s.

The bond market is expecting the consumer price index to rise an average of 2.65% annually over the the next five years, but that’s moving in the wrong direction and above the Fed’s 2% inflation target.

Market-based price signals should be given more weight at a time when the “hard data” isn’t yet providing the Fed the right indicators to slow the pace of tightening. Core inflation continues to run well above target, and even while there are signs that inflation should slow in the months to come, the Fed would likely want at least three months of data to feel reassured. At the same time, neither the labor market nor financial markets are showing enough evidence of cooling, with employment remaining strong and markets looking healthier than they did a month ago.

The Fed’s evolving approach has been like cooking a bag of microwave popcorn. Like conducting monetary policy, it’s a data-dependent process, as anyone who has ever burned popcorn despite precisely following the directions on the bag can attest. In the first two minutes the bag heats up and expands and kernels start to pop with accelerating intensity. That’s more or less what we’ve seen from the Fed since March as it aggressively raised rates from 0% at a time of high inflation. It’s not until the popping slows that you have to pay closer attention. You can’t see inside the bag, so you watch for other signs that the process is complete (or that you’ve gone too far), such as no more popping sounds or a burning smell. This is the phase the Fed is moving into now.

Conclusive data from the inflation or labor markets showing that the Fed has done its job won’t come until the first quarter of 2023, at the earliest. In the meantime, market signals should carry more weight, and unfortunately, the inflationary response of markets in October to the Fed’s perceived tightening path suggests we haven’t yet priced in enough interest rate increases. We should be prepared for the Fed’s terminal rate to end up north of 5%.

More From Other Writers at Bloomberg Opinion:

How Front-Loading Rate Hikes Risks Instability: Mohamed El-Erian 

Will Jerome Powell Be Like Volcker or Burns?: Bill Dudley

The Fed’s Next Crisis Is Brewing in Treasuries: Robert Burgess

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Conor Sen is a Bloomberg Opinion columnist. He is founder of Peachtree Creek Investments and may have a stake in the areas he writes about.

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