The Market is Pricing in Too Many Fed Hikes, Says the Former Dallas Fed Chief

Former Dallas President Robert Kaplan says the market is getting ahead of itself.

The bond market is getting too aggressive in pricing in Federal Reserve rate hikes, a former central bank official says.

Robert Kaplan, the former Dallas Fed president, told a Goldman Sachs podcast that the central bank was right to increase rates in September and would probably be right to increase them again in December but pause in October.

He said the inflation rate, both on a monthly and a year-on-year basis, is "problematic," with even monthly numbers on an annualized basis running closer to 3%.

The Fed's dot plot, he notes, shows one more rate hike this year. But financial markets have gone beyond that. As of Thursday morning, they're pricing in at least three more hikes by the middle of June.

"The AI infrastructure part of the economy and AI adoption part of the economy is booming, there's no question about that. Defense spending, for obvious reasons, is very strong. However, when you look at autos, housing-related companies that sell to low-, moderate-income consumers, business isn't terrible but it's pretty sluggish or weak," he said.

"So the interest-sensitive parts of the market that are affected by the fed funds rates are already, in my opinion, not overheated," he said.

A quarter-point rate hike from here would get the federal funds rate between 4% and 4.25%, what Kaplan says is in the neighborhood of the neutral rate that neither accelerates nor restricts the economy. "Maybe I need to do one more to be slightly restrictive, but I don't now that I need to do a lot more than that," he said.

Kaplan says the market - and the podcast was recorded on Tuesday, before the 2-year yield BX:TMUBMUSD02Y rose another 12 basis points - is building a cushion because traders don't yet understand the reaction function of new Fed chief Kevin Warsh as well as the inability of the Trump administration to end the war in Iran and the possibility that higher-for-longer oil prices will "bleed" into 30 or 40 other items.

He also discussed long-term yields BX:TMUBMUSD10Y topping 5%, which he blamed on the fiscal situation.

He said the thought was earlier in the year that economic growth would slow the increase of the deficit, but recently the Congressional Budget Office revised up its estimates. "And it's probably causing the market to be a little bit more discouraged that we have got a grip," he said. Kaplan added the other problem is there has been no fiscal consolidation plan announced.

-Steve Goldstein