Interest-rate markets see the Federal Reserve raising its policy interest rate more than the monetary authorities in order to bring inflation to heel-even if it risks pushing the economy into a recession.
To the surprise of absolutely nobody, the Federal Open Market Committee this past week increased its target range for federal funds by 25 basis points, to 3.75%-4%, by a unanimous vote. (A basis point is a hundredth of a percentage point.) At the same time, the policy-setting panel unveiled a new Summary of Economic Projections that showed a median expectation of another 25-basis-point hike by December, to a range of 4%-4.25%.
For 2027, the median year-end SEP called for no further increase in the fed-funds target, based on seven of the 18 votes on the policy-setting panel. In a client note based on past sentiments of Fed officials, Deutsche Bank economists infer that five of next year's voting members on the FOMC would favor holding steady through 2027, while two are seen favoring another 25-basis-point hike, and four would favor some rate cuts. (All seven members of the Board of Governors and the 12 Fed district bank presidents may submit projections. Fed Chairman Kevin Warsh, who has spoken out against forward guidance of policy, declines to participate in providing his "dots" for the SEP graphs.)
While numerous Fed watchers characterize the outcome of the FOMC meeting as "hawkish," fed-funds futures traders look for even more rate increases than those implied by the dot plot. Along with fed-funds futures, the two-year Treasury note yield points to further Fed hikes, and it has proved to be a more redoubtable guide to future Fed policies than the pronouncements of the monetary mandarins, as many canny observers such as DoubleLine "Bond King" Jeffery Gundlach have pointed out. (Hat tip to Cambria Investment Management co-founder Meb Faber for updating the evidence with his X.com post .)
In other words, the markets are ahead of the Fed in looking for future rate hikes. As the chart nearby shows, fed-funds futures imply three 25-basis-point hikes by December 2027, to a target range of 4.5%-4.75%. The CME FedWatch tool sees that level being reached by next April's FOMC meeting, with the panel holding steady for the rest of 2027. The two-year Treasury yield of 4.68% similarly points to more rate hikes than the FOMC dot plot.
At the same time, the benchmark Treasury 10-year note traded above 5% in the wake of the Fed's rate hike on Wednesday. Asked about this at the postmeeting news conference, Warsh called the benchmark yield the most important asset price of any. He ascribed the yield rise, from a low just 4% at the start of the Iran war, to three factors: the economy's strength, with the Atlanta Fed's GDPNow tracking at 5.1% annual growth in the current quarter; competition for capital, notably capital spending for artificial-intelligence projects, which has sparked corporate bond issuance at a record pace; and geopolitical factors, from which one reasonably can infer the war.
Warsh made no mention of the massive budget deficits, notably in the U.S., running at about 6% of gross domestic product despite the strong growth data. To be sure, yields are up in nearly every major bond market around the globe, and many of them also are having to fund substantial government deficits.
Still, it would seem that markets are taking seriously the FOMC's statement that the rate hike "will support a timelier return" to the Fed's 2% inflation goal. "The Committee will delivery price stability," its policy statement tersely concluded.
Much of the current inflation results from the rise in energy prices resulting from the war with Iran. Monetary policy can do little to lower the price of crude oil, which has soared past the $100 a barrel mark, more than 50% higher than at the war's start at the end of February. And policy can do even less for gasoline and still less again for diesel fuel, which has hit records owing to refinery capacity.
Critics say simply blaming energy costs for the persistent above-target inflation is a cop-out. The core personal consumption expenditure index-the version of the Fed's preferred inflation measure that excludes food and energy prices-has exceeded the Fed's 2% target for over 60 months, James Bianco, the eponymous head of Bianco Research, pointed out in a client note this past week. Moreover, core PCE inflation has risen to a 3.3% annual rate in the 12 months ended in July, from 2.6% on April 25.
But the only way to bring inflation down to the Fed's target is by "demand destruction," writes David Rosenberg of Rosenberg Research, unless oil prices come down quickly. The only way by which interest rates bring inflation back to the 2% target is "by destroying enough demand to offset the supply loss. That is a recession by design," he concludes.
That hasn't happened since the days of Paul Volcker, who crushed double-digit inflation in the early 1980s, he added. Other previous Fed chairs have been tested early in their terms, notably Alan Greenspan in 1987, when Fed rate hikes and high bond yields sent the Dow Jones Industrial Average plunging 22% on Oct. 19 of that year.
A more likely outcome this time is a slowing of currently steamy growth while inflation remains above the Fed's desired 2% target. That could approach the unsatisfying state of stagflation. Which of the Fed's dual mandates-maximum employment or price stability-will take precedence? Warsh insists the latter will prevail, notwithstanding more calls by President Donald Trump for lower, rather than higher, rates.
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