Dominique Dwor-Frecaut, a former associate with the Latest York Fed and outlier from the remainder of the financial-market pack, is standing by a daring call she made a 12 months ago: She says the Federal Reserve must hike its benchmark rate of interest to eight% from the present level of 4.5%-4.75% to stabilize inflation, and will still get there.
The U.S. hasn’t seen an 8% fed-funds rate since July-October 1990 — when inflation as measured by the annual headline consumer-price index hovered between 4.8% and 6.3% — but such a level is smart to Dwor-Frecaut. That’s since it is tied to the Taylor Rule — a generally accepted rule of thumb used to find out where rates of interest must be relative to the present state of the economy. Based on January U.S. data, the annual headline CPI rate was 6.4%, while the unemployment rate stood at a more-than-half-century low of three.4%.
A stream of stronger-than-expected data indicates that the U.S. economy is holding up much better than many had expected after almost a full 12 months of Fed rate hikes. That surprising strength is giving rise to the chance that policy makers might want to once more boost the dimensions of their next rate increases, after having dialed down their Feb. 1 hike to a quarter-of-a-percentage-point. Minutes of the Fed’s Jan. 31-Feb. 1 meeting, scheduled for release at 2 p.m. Eastern on Wednesday, are more likely to reveal how widespread support was for an even bigger hike and will proceed to be going forward.
Financial markets are finally coming around to the Fed’s message of ongoing rate increases, as bond investors consider additional hikes for this 12 months. Treasury yields have followed the trajectory of rate expectations and trended higher. Meanwhile, global bonds — which move in the other way of yields — are within the strategy of erasing all the gains they’ve made this 12 months, based on the Bloomberg Global-Aggregate Total Return Index.
“The Fed goes to want to double down because we’re coming out of several a long time of very low interest rates, through which households and businesses have been in a position to lock in very low rates of interest for a really very long time,” said Dwor-Frecaut, now a Los Angeles-based senior strategist for research provider Macro Hive of London.
“The U.S. is more resistant to monetary-policy tightening than it was 10 years ago due to household deleveraging and really strong balance sheets. Policy tightening hasn’t been strong enough to have enough of an impact, even in interest-rate-sensitive markets like housing where prices have stabilized.” (Even so, existing home sales have dropped for 12 straight months, in line with data released on Tuesday.)
Dwor-Frecaut’s reasoning boils right down to three key points: that the U.S. is caught in a high inflation regime through which “wages and costs have grow to be entangled, just as within the Seventies and Nineteen Eighties”; monetary policy stays “too loose”; and the Fed could fall further behind the curve, given the very long time it takes for rate increases to filter through the economy.
She said the fed-funds rate should already be around 8% — throughout the estimated range cited by former Fed regional presidents Jeffrey Lacker and Charles Plosser and economists at Stifel, Nicolaus & Co., and a bit above the 7% level envisioned by St. Louis Fed President James Bullard in November.
As of Wednesday, traders saw a 50% likelihood of the Fed lifting borrowing costs to five.25% to five.5% by July, and almost 25% likelihood of something higher, but that also won’t be enough to get the job done, in line with Dwor-Frecaut, who describes herself as someone who revels “in difficult the consensus, though even the consensus may be right sometimes.”
In counting on the Taylor Rule, she said that “I attempted to seek out something so simple as possible and never impacted by technical issues. What struck me is that should you checked out the fed-funds rate and Taylor Rule because the Seventies, the story again, repeatedly is that the Fed starts tightening when the gap between the Taylor Rule and actual fed-funds rate is wide, and stops when it has closed.”
The Taylor Rule is a “crude but easy and practical way of capturing macroeconomic imbalances,” and, by waiting until the gap is wide before tightening, policy makers are “all the time having to play catch up,” said Dwor-Frecaut, who worked as a senior associate in market operations monitoring and evaluation on the Latest York Fed from 2016 to 2018. “The thing that’s striking about this tightening cycle is that they [Fed officials] began when the gap was the largest because the Seventies oil shock,” putting them behind the curve.
Financial markets were calmer on Wednesday following Tuesday’s aggressive price motion, which sent the policy-sensitive 2-year Treasury yield
TMUBMUSD02Y,
4.674%
to its highest level since July 2007 and handed U.S. stocks to their worst day since mid-December. As of Wednesday afternoon, all three major U.S. stock indexes DJIA SPX COMP were higher, together with the ICE U.S. Dollar Index DXY, while most Treasury yields moved lower ahead of the Fed minutes.
By way of the character of inflation, “it’s each a supply and demand shock because it was within the 70s,” in line with Dwor-Frecaut. “The commonality is that should you plot wages against inflation, you will notice a feedback loop between the 2. This negative feedback loop is what’s going to make it super-hard to bring down.”
As well as, she said, the reopening of China and its possible impact on global energy prices might be one possible trigger that sends the U.S. into an inflationary shock, “which can be a disaster for the U.S.”