Opinion: Opinion: What Bullard Got Wrong About a 7% Fed Fund (and Why He Said It Anyway)

An influential Federal Reserve official briefly shocked SPX stock,
-0.31%
and bond TMUBMUSD10Y,
3.805%
markets on Thursday by warning that the central bank may have to raise rates much further than the market expected. But the official omitted key information that undermined his argument, suggesting that the market was probably right in the first place.

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

Tighter monetary policy isn’t just about raising interest rates anymore; it’s also about shrinking the Fed’s balance sheet and forward guidance.

Some background first, and then I’ll explain what the Fed official did wrong.

Bullard’s speech

St. Louis Fed President James Bullard said in a speech Thursday that federal funds FF00,
+0.00%
– now in a range of 3.75% to 4% – should probably rise much further to dampen inflation. Without forecasting a specific number, Bullard added a chart saying Fed Funds rates would need to rise to between 5% and 7% to be “enough restrictive.”

Now reading: Fed’s Bullard says benchmark rate in range of 5%-7% may be needed to lower inflation

Bullard’s map

St Louis Fed

Most observers had expected the Fed’s so-called closing 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 generally (though not universally) accepted rule of thumb that shows how high the federal funds rate should be to create enough unemployment to bring inflation back to its long-targeted level. 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 proves more stubborn than current projections.

A 7% Fed Funds rate would likely push stock and bond prices much lower, which put a major damper on markets that recovered over the past week in the belief that inflation had begun to cool.

Vivien Lou Chen: Financial markets are spinning again with ‘peak inflation’ story. This is why it’s complicated.

Forward Guidance

What Bullard said was inconsistent with what Fed Chairman Jerome Powell had said at his last press conference: that the Fed should raise rates higher and longer. Bullard’s chart just gave a very dramatic number that Powell had merely referred to.

What Bullard ignored in his analysis was that monetary policy tightening is no longer just about raising interest rates; it is also about shrinking the Fed’s balance sheet and forward guidance, both of which also effectively tighten monetary policy. In other words, a 4% federal funds rate today cannot be directly compared to a 4% federal funds rate in Paul Volcker’s time, what the Taylor rule does and what Bullard’s chart does.

A recent paper by Federal Reserve Banks economists in San Francisco and Kansas City argues that, after adding in the economic and financial impact of forward guidance and quantitative tightening, the target rate (as of September 30) was 3%-3.25% equivalent in monetary tightness to a proxy fed funds of about 5.25%. After a 75 basis point increase on Nov. 2, I estimate the proxy rate is now around 6%.

That’s just 100 basis points of tightening away from Bullard’s doomsday scenario. But the market had already priced in 125 basis points of tightening!

And that is the most extreme value. Plug in other inflation and unemployment forecasts and you get lower numbers from the Taylor rule. The median value is about 3.75%, meaning that the nominal Fed Funds rate is already in “enough restrictive” territory. The proxy fed funds rate, which plays a role in the monetary policy contribution of forward guidance and QT, is already in the middle of the range.

That means the Fed’s policies may already be “restrictive enough” to bring inflation down to 2%, which is certainly not the message Bullard and his colleagues want the markets to hear. If markets believed it, forward guidance would be weaker and proxy rates would fall and the Fed would have to raise rates further.

We know why Bullard said what he said: he does forward guidance and tries to get the financial markets to do the Fed’s job. If stock and bond markets started 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 will always shut up the markets. Right now, they’re doing that by emphasizing how high interest rates could get and how long the Fed could keep them there. The more markets deem a 7% Fed Funds rate likely, the less likely the Fed will have to raise rates as low as 5.50%.

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

Rex Nutting is a MarketWatch columnist who has reported on the economy and the Fed for more than 25 years.

More jaws from the Fed

Fed’s Waller feels more comfortable with the idea of ​​potentially slowing the pace of rate hikes given recent data

Fed’s Daly sees interest rates eventually coming into the range of 4.75%-5.25%.

Fed’s Brainard says it ‘soon’ appropriate to move to a slower pace of rate hikes

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