Bloomberg market commentator Ven Ram believes that the Fed’s guidance on the neutral rate may be flawed , and it may need to take more aggressive measures than the market expects to curb inflation.
While the Fed’s latest summary of economic forecasts released in June showed policymakers’ median expectations for the long-term federal funds rate at 2.5%, there is little reason to think the neutral rate will be lower with headline U.S. inflation at 9.1% From December 2018 levels, when the Fed ended its last rate hike cycle, policymakers expected a neutral rate of 2.75% and inflation around 2%.
Mohamed El-Erian, former chief executive of PIMCO, believes the neutral rate should be “at least half a percentage point higher” than the Fed’s forecast of 2.5%.
Given that inflation is currently well above its 2% target, the Fed may have to raise its rates into a restrictive range. In June, Fed officials’ expectations for a ceiling on the federal funds rate next year were as high as 4.1% , suggesting some officials believe the Fed needs to raise rates much more than the market currently expects.
The Fed will also tighten by about 100 basis points by the end of the year, according to the pricing of overnight index swaps . Much of this outlook stems directly from Powell’s dovish rhetoric – that “we are now around neutral rates.”
While the market believes the Fed’s rate hike cycle is nearing its end, this time it’s far more complicated. Economic growth is slowing, made worse by the negative feedback from a “technical recession”. However, given the uncertainty about inflation, the Fed may have no choice but to keep raising rates.
Powell himself has said that the Fed’s median rate forecast for a rate hike to 3.8% in 2023 remains the best guide, which is higher than the market’s current expectations. But Ven Ram warned that in repricing the Fed’s rate hike expectations, investors may be overly focused on Powell’s comments on the neutral rate, assuming the Fed is still taking the playbook for 2018. This will put them at risk for months to come.