Opinion: The bond market has a strong view on inflation, but what about a recession?
Every time the Federal Reserve starts to tighten financial conditions, the markets try to guess how far the central bank will go.
In fact, at a time when it provides its estimates of future policy in a framework known as “points”, the Fed himself provides guidance on where the federal funds rate will land. For 2023 and 2024, the median rate is estimated by FOMC members responsible for policy at 3.375%; 4.375% is expected in 2023.
A number of former Federal Reserve officials have also weighed in on what they think the policy should do. Alan Blinder, former Fed Vice Chairman, warned to go slow. Lawrence Lindsey, a former Fed governor, called the practice of raising the federal funds rate above the rate of inflation something that worked in the past. Judy Shelton, an economist once nominated to become a member of the Federal Reserve board, mocked the Fed for not raising the rate to the rate of inflation as it had done before.
But, of all the comments that have been made, the most important one is being made every day in the bond market. The fact that the 10-year note yields TMUBMUSD10Y,
is trading up to, and currently below, the 3% mark is a clear vote of confidence that inflation will not spiral out of control. With the fed funds rate in the upper range of 2.5% currently and inflation at 9.1% on the consumer price index, only a fool would buy and hold 10-year notes yielding 3% or less if he thought inflation would last. Obviously, the bond market doesn’t think so.
However, this does not make it perfectly clear what the bond market is thinking.
Mud fight over the recession
Chris Waller and a co-author, and Larry Summers and his co-authors, have a little mud on the concept of whether the Fed can bring inflation down without having a recession, or at least a significant increase in the rate of the unemployment.
Waller, a Federal Reserve Board Governor, would make a clear argument that the Fed can raise rates and not necessarily push the economy into a recession. This possibility would make the Fed’s rate hike policies a little easier to swallow publicly and politically. Summers and his co-authors take the opposite view that to reduce the inflation rate, the unemployment rate must rise.
It is not certain that the bond market has a position on these questions. History clearly shows that inflation only came down from very high levels after recessions. These recessions have usually occurred after the Federal Reserve raised rates significantly. History has yet to produce a situation where interest rates rise and inflation falls significantly without a recession. That doesn’t mean Waller won’t be the best in this debate. It just means he has no history as a winger.
The “real” federal funds rate—a red herring?
Historically, it’s true that the Fed has always had a fed funds rate above the rate of inflation whenever a recession has started. However, this was true even in recessions that started and ended and failed to bring the rate of inflation back to a level of price stability.
Right now, with inflation so high and the fed funds rate so low, I don’t know anyone who thinks we’re going to push that rate above the rate of inflation or who would approve of it. However, the behavior of the bond market suggests that the inflation rate will decline, and there might be a time when the fed funds rate and the inflation rate might have a more normal historical relationship. But are we going to get to this point by raising the fed funds rate or by going into a recession first?
One of the things I find most interesting is that few people at the Federal Reserve are willing to talk about it. During his last press conference, Fed Chairman Jerome Powell said that the federal funds rate was finally reaching the neutral position. This is quite an astonishing statement. How is a rate of 2.5% neutral when the CPI is running at 9.1%? I can’t begin to understand this.
The Fed may continue to believe that much of the inflation will go away on its own. Remember that the whole tightening episode was delayed by the Fed saying that inflation was going to be transitory. It strikes me that the Fed still holds that belief, but they’re worried about repeating that phrase because they’ve had to eat those words once in public and they didn’t taste very good.
However, CL.1 oil prices,
eased and there was a strong recovery in commodity prices. The ISM manufacturing price indicator fell sharply in July. And there’s reason to think that some of the inflation is actually quite temporary and will more or less subside on its own. The supply chain is being repaired. But wage inflation accelerated. Not all toothpaste will go back into the tube on its own; the Fed is going to have to scrape it there using monetary policy. The Fed does not want to engage in a discussion on this until good news is on the table.
The bond market impresses me, in part because it invested very early in the notion of controlling inflation. I wonder how high the fed funds rate will have to go before it starts delivering results. The bond market suggests that it won’t have to go very high at all. After that, you are on your own.
I can understand the argument Waller is trying to make, but if I had to take sides it would be with Summers, who is looking for a recession. This is because recessions stop inflation. And I think that’s what the bond market knows and why its yield curve has been inverted.
Robert Brusca is Chief Economist of FAO Economics.