The Fed may already have reached its optimum interest rate

With inflation in the US starting to fall, the debate has inevitably shifted to when the Federal Reserve should stop raising interest rates, and a legendary bond investor just warned that the central bank is at risk of overshooting its targets.

While inflation in the US has recently shown some positive signs of normalization, the Federal Reserve, architect of the six rate hikes this year that many feared could push the economy into recession, does not appear to be planning to stop.

Critics of the Federal Reserve’s aggressive strategy have said the central bank risks exceeding its interest rate targets by holding them too high for too long. Part of that criticism has to do with the speed of interest rate hikes this year, which has left little time to assess the effect of each hike on inflation and the state of the economy.

And one of the things the Fed may be missing is the “dangerous” levels of hidden leverage — off-balance sheet and largely unregulated debt — currently circulating the economy, warns Bill Gross, billionaire bond investor and co-founder of Pimco . one of the largest hedge funds in the world.

There is a very real risk of “too much hidden leverage” in today’s economy, Gross wrote in an op-ed for the Financial times Monday, and he advised the Fed to consider whether it has already reached an “optimal” interest rate level.

“The danger of overshooting and the need for forward-looking monetary policy strongly argue in favor of this,” he wrote. “The Fed should now stop raising rates and wait to see if the punch bowl has been sufficiently drained.”

“Shadow Guilt”

In 2002, Fortune Bill Gross called the “Bond King,” a nickname also used this year in the title of a biography written by NPR’s Mary Childs. Gross retired in 2019 after a largely uneventful stint at Janus Henderson, but his revolutionary work in the bond market earned him the nickname and at one point controlled the largest bond fund in the world.

Gross’ propensity for bonds – a form of debt sold by companies or governments – makes him an authority on warnings about how large amounts of hidden debt are rocking the economy today.

In his opinion piece for the FTGross wrote that it was “important to recognize the dangerous levels of debt” circulating the economy today, citing a recent survey by the Bank of International Settlements that found investors have taken on a huge amount of “off balance sheet debt”. that entails major risks for the American economy.

The total value of this “hidden ‘shadow bank’ debt” is $65 trillion, Gross wrote. He advised the Fed to pay more attention to shadow banks, the network of non-bank entities including creditors and brokers that don’t fit into the traditionally regulated banking system, and sounded the alarm for “too much hidden leverage, too much shadow debt behind closed doors. ”

Gross isn’t the only market watcher to warn of the extreme risks of high debt in an increasingly uncertain economic climate. Nouriel Roubini, an NYU economist and president of economic consulting firm Roubini Macro Associates, warned during a November interview with Fortunewhile huge mountains of public and private debt threaten to send the economy into a protracted downward spiral.

Gross wrote that the Fed should hold on to current interest rates, which are now in the range of 4.25% to 4.5% after this month’s last hike, and feel the economy before moving any further. He referred to the so-called R-star rate (also known as the real neutral interest rate), which represents an ideal interest rate in an economy at full employment, and argued that both the R-star and the current federal funds rate are already at an optimal level, and if they are raised further, given the hidden debt forces at play, could lead to more “trouble ahead”.

Small chance of a tariff break

Gross did add that the current interest rate target is only ideal if inflation “appears to be approaching acceptable levels,” so the bond king can be encouraged by the latest trends.

In November, US consumer prices rose 7.1% year-on-year, up from 7.7% in October, marking the fifth straight inflation slowdown since peaking at 9.1% in June. Prices have fallen for key elements, including gasoline, and may have even begun to fall for housing, prompting some to put the worst behind them.

The latest data on prices has encouraged many economists, from Nobel laureate Paul Krugman to those at the University of Michigan Justin Wolfers, to declare that inflation has already peaked and that the economy is moving towards normalization. Even former Treasury Secretary Larry Summers, who in the past predicted a deep recession and high unemployment due to delayed Fed action, recently admitted that prices fell faster than he expected.

“For now, however, the economy appears to be stronger and inflation and inflation expectations are a little lower than I thought a few months ago,” Summers said. wrote on Twitter last week after the release of the latest CPI report.

But despite encouraging signs, the Fed has indicated that there is still a long way to go before inflation returns to acceptable levels for the central bank.

At the last central bank meeting of 2022 earlier this month, Fed Chairman Jerome Powell warned “we still have some ways to go,” and while he left the door open for smaller rate hikes next year, there is little to no chance of a raise pauses.

“It is our judgment today that we are not yet sufficiently restrictive in policy,” he said. “We will stay on track until the job is done.”

This story was originally on Fortune.com

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