Whether this turns out to be right will depend on a number of developments that are difficult to predict. How fast will inflation go down? Where will bottom hit when the economy reopens, demand shifts from services to goods, and supply chain disruptions ease? What will happen in the labor market, where annual wage inflation is above 5% and the unemployment rate is on track to reach its lowest level since the early 1950s in just a few months? Will more people come out of the sidelines by increasing the job offer? Coupled with moderating inflation, this could allow the Fed to stop raising rates to a neutral level of around 2.5%. Or a tightening labor market and stubborn inflation could force the Fed to be much more aggressive.
Among the major uncertainties: how will the Fed tightening affect financial conditions and how will such conditions affect economic activity? This is central to Fed Chairman Jerome Powell’s thinking on monetary policy transmission. As he stated in his March press conference: “Politics works through financial conditions. This is how it comes to the real economy. “
He’s right. Unlike many other countries, the US economy does not respond directly to the level of short-term interest rates. Most home borrowers are not interested because they have long term fixed rate mortgages. And, again unlike many other countries, many US households hold a significant portion of their wealth in stocks. As a result, they are sensitive to financial conditions: stock prices affect how wealthy they feel and how much they are willing to spend rather than save.
So far, the Fed’s removal of the stimulus hasn’t had much effect on financial conditions. The S&P 500 Index was down only about 4% from its early January peak, and still a lot from its pre-pandemic level. Likewise, the yield on the 10-year Treasury bill stands at 2.5%, up just 0.75 percentage points from a year ago and still well below the inflation rate. This is happening because market participants expect higher short-term rates to undermine economic growth and force the Fed to reverse course in 2024 and 2025, but these same expectations prevent tightening of financial conditions which would make it more likely. such an achievement.
Investors should pay more attention to what Powell said: Financial conditions need to be tightened. If that doesn’t happen on its own (which seems unlikely), the Fed will have to rock the markets to get the desired response. This would mean significantly increasing the federal funds rate from what is currently expected. One way or another, to keep inflation in check, the Fed will have to push bond yields higher and share prices lower.
This column does not necessarily reflect the opinion of the editors or Bloomberg LP and its owners.
Bill Dudley, a Bloomberg Opinion columnist and senior advisor to Bloomberg Economics, is a senior advisor to Princeton University’s Griswold Center for Economic Policy Studies. He was chairman of the Federal Reserve Bank of New York from 2009 to 2018 and vice chairman of the Federal Open Market Committee. Previously, he was US chief economist at Goldman Sachs.
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