(This column was originally published Nov. 17. It has been updated with a reference to Mary Daly’s speech on Nov. 21.)
An influential Federal Reserve official briefly spooked the stock
markets on Thursday by warning that the central bank may have to raise interest rates much further than the market has been expecting. But the official left out some important information that undercut his argument and which suggested that the market probably had it right in the first place.
Background reading: This is the chart that is rattling U.S. financial markets Thursday
“ Tightening monetary policy isn’t just about raising interest rates anymore; it’s also about reducing the Fed’s balance sheet and about forward guidance.”
First some background, and then I’ll explain what the Fed official got wrong.
St. Louis Fed President James Bullard said in a speech Thursday that the federal funds rate
—now in a range of 3.75% to 4%—would probably have to rise much further to put a damper on inflation. Without forecasting a specific number, Bullard included a chart that said the fed funds rate would have to rise to between 5% and 7% in order to be “sufficiently restrictive.”
Bullard’s chart. The gray area shows where policy ought to be, according to the Taylor Rule. The blue line shows where it is.
St. Louis Fed
Most observers had been expecting that the Fed’s so-called terminal rate would be around 4.75% to 5.5%, so Bullard’s warning came as a bit of a shock.
Bullard based his estimates on the Taylor Rule, which is a commonly (although not universally) accepted rule of thumb that shows how high the federal funds rate would need to be to create enough unemployment to bring the inflation rate back down to the targeted 2% level.
There are several variations of the Taylor Rule, the most extreme of which would require a federal funds rate of 7% (according to Bullard’s chart) if inflation proved to be more persistent than current forecasts project.
A 7% fed funds rate would imply much lower stock and bond prices, which was a big downer in markets that rallied in the last week on the belief that inflation was beginning to cool.
What Bullard said wasn’t out of line with what Fed chair Jerome Powell had said in his last press conference: that the Fed would have to raise rates higher and for longer. Bullard’s chart just put a very dramatic number on what Powell had only hinted at.
What Bullard ignored in his analysis was that tightening monetary policy isn’t just about raising interest rates anymore; it’s also about reducing the Fed’s balance sheet and about forward guidance, both of which also effectively tighten monetary policy. In other words, a 4% federal funds rate today can’t be compared directly with a 4% federal funds rate back in Paul Volcker’s day, which is what the Taylor Rule does and which is what Bullard’s chart does.
A recent paper by economists at the San Francisco and Kansas City Federal Reserve Banks argues that, after adding in the economic and financial impact of forward guidance and quantitative tightening, the target rate (as of Sept. 30) of 3%-3.25% was equivalent in monetary tightness to a “proxy fed funds” of around 5.25%. After a 75-basis-point hike on Nov. 2, I figure that the proxy rate is now around 6%.
On Monday, San Francisco Fed President Mary Daly concurred with that thinking, saying that the research shows that the current impact of monetary policy on financial conditions is akin to a 6% federal funds rate, significantly higher than the 3.75% to 4% official rate.
“As we make decisions about further rate adjustments, it will be important to remain conscious of this gap between the federal funds rate and the tightening in financial markets. Ignoring it raises the chances of tightening too much,” Daly said.
That’s just 100 basis points of tightening away from Bullard’s doomsday scenario. But the market was already pricing in 125 basis points of tightening!
And that’s the most extreme value. Plug in other predictions for the inflation and unemployment rates and you get lower numbers out of the Taylor Rule. The median value is about 3.75%, which means the nominal fed funds rate is already in “sufficiently restrictive” territory. The “proxy fed funds rate,” which factors in the contribution to monetary policy of forward guidance and QT, is already in the middle of the range.
That means the Fed’s policy may already be “sufficiently restrictive” to bring inflation down to 2%, which is definitely not a message Bullard and his colleagues want the markets to hear. If the markets believed it, then forward guidance would be weaker and the proxy rate would plunge and the Fed would have to raise rates more.
We know why Bullard said what he said: He’s engaging in forward guidance, trying to make financial markets do the Fed’s work for it. If the stock and bond markets began to anticipate a “pivot” as the Fed hit its terminal rate or even to rate cuts next year, it would undermine what the Fed is trying to accomplish now.
Fed officials are always going to jawbone the markets. That’s what forward guidance is. Right now, they do that by emphasizing how high interest rates might go and how long the Fed might keep them there. The more the markets believe a 7% fed funds rate is probable, the less likely it is that the Fed will have to raise rates to even 5.50%.
It’s the job of the Fed to bluff, and it’s the market’s job to call that bluff.
Rex Nutting is a columnist for MarketWatch who’s been reporting about the economy and the Fed for more than 25 years.