Opinion: Opinion: What Bullard got wrong about a 7% fed fund (and why he said it anyway)

An influential Federal Reserve official took a brief look at SPX stock,
-0.31%
and TMUBMUSD10Y bond,
3.769%
markets on Thursday warning that the central bank may have to raise interest rates much further than the market expected. But the official left out some important information that weakened his argument and suggested that he was probably right about the deal in the first place.

Background reading: This is the chart that is shaking the US financial markets on Thursday

Monetary policy is no longer about raising interest rates; it is also about reducing the Fed’s balance sheet and forward guidance.

First some background, and then I’ll explain what the feds got wrong.

Bullard’s speech

St. Louis Fed President James Bullard said in a speech on Thursday that the federal funds rate is FF00,
+0.00%
— now in the 3.75% to 4% range — would probably need to rise much longer to dampen inflation. Without predicting a specific number, Bullard included a chart that said the fed funds rate would need to be raised to between 5% and 7% to be “restrictive enough.”

Read now: Fed’s Bullard says benchmark interest rate in 5%-7% range may be needed to reduce inflation

Bullard’s Charter

St. Louis fed

Most observers had expected the Fed’s terminal rate to be around 4.75% to 5.5%, so Bullard’s warning came as a shock.

Bullard based his estimates on the Taylor Rule, a commonly (though not universally) accepted rule of thumb that shows how high the federal funds rate would have to be to create enough unemployment to bring the inflation rate to back to the long overdue goal. 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 the Bullard chart) if inflation were to be more stable than current forecasts project.

A 7% fed funds rate would likely push stock and bond prices much lower, and that was a big letdown in markets that had emerged over the past week on the belief that inflation was starting to cool.

Vivien Lou Chen: Financial markets run with a story of ‘peak inflation’ again. This is why it is complicated.

Forward guidance

What Bullard said was not in line with what FED chairman Jerome Powell said in his last press conference: that the Fed would have to raise rates higher and longer. Bullard’s chart just put a very dramatic number on what Powell was implying.

What Bullard overlooked in his analysis was that monetary policy tightening is no longer just about raising interest rates; it’s also about reducing the Fed’s balance sheet and bringing forward guidance, effectively tightening monetary policy. In other words, a 4% federal funds rate today cannot be directly compared to a 4% federal funds rate back in Paul Volcker’s day, which is what the Taylor Rule and the Bullard chart do.

A recent paper by economists at the Federal Reserve Banks of San Francisco and Kansas City argues that after factoring in the economic and financial impact of forward guidance and quantitative tightening, the target rate (as of September 30) of 3% – 3.25%. equivalent in monetary intensity to “proxy maintained funds” of approximately 5.25%. After a 75 point rise on November 2nd, I understand the proxy rate is now around 6%.

That’s just a 100 basis point tightening away from Bullard’s day scenario. But the market was already pricing in 125 basis points of tightening!

And that is the greatest value. Throw in other predictions for the inflation and unemployment rates and you get lower numbers from the Taylor Rule. The median value is around 3.75%, which means that the nominal funds rate is already in “quite restrictive” territory. The “proxy fed funds rate”, which takes into account the contribution of forward and QT guidance to monetary policy, is already in the middle of the range.

That means the Fed’s policy may already be “tight enough” to reduce inflation to 2%, which is hardly the message Bullard and his colleagues want the markets to hear. If the markets believed it, there would be weaker forward guidance and the proxy rate would fall and the Fed would have to raise rates more.

We know why Bullard said what he said: He is engaging in forward guidance, trying to make financial markets do the Fed’s work for him. If the stock and bond markets began anticipating a “pivot” to slower rate hikes or even rate cuts next year, it would undermine what the Fed is trying to achieve this year.

Fed officials are always going to jawbone the markets. Right now, they do that by focusing on how high interest rates could go and how long the Fed could keep them there. The more the markets believe a 7% fed funds rate is likely, the less likely the Fed will have to raise rates to even 5.50%.

It’s the Fed’s job to bluff, and it’s the market’s job to call that bluff.

Rex Nutting is a columnist for MarketWatch who has been reporting on the economy and the Fed for over 25 years.

More jawboning from the Fed

Fed’s Waller is more comfortable with the idea that the pace of rate hikes could be slowed in light of recent data

The Fed’s Daly sees interest rates eventually going into a range of 4.75%-5.25%.

Fed’s Brainard says ‘soon’ appropriate to step down to a slower pace of rate hikes

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