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The risk that a hawkish Fed produces a policy mistake

June 15, 2022
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Stung by the persistency and level of inflation and the accusation of being behind the curve the Federal reserve has cranked up its hawkishness

This is reflected in a significant shift in market interest rate expectations since the Russian invasion of Ukraine in late February.

Chart 1: A significant shift in US interest rate expectations since late February

Source: Refinitiv

The next few FOMC meetings are expected to deliver 50bps increases in the Fed funds and see the contraction of both Treasury and MBS holdings.

A key question is whether the projected rise in interest rates will be seen as too much for the economy to accommodate, constituting a policy mistake?

What is unusual is that the Fed are tightening at a time when both Consumer Confidence and Real Incomes have fallen to levels last seen at the lows of the GFC recession. Normally the Fed would be considering accommodation with indicators at these levels.

Chart2: The Fed are tightening into extremely weak Consumer Confidence and Real Income levels

Source: Refinitiv

Another clear risk is that the Fed have turned more hawkish just as aggregate financial conditions ( a measure of the combined impact of shifts in monetary policy, the credit cycle and foreign exchange) have tightened very rapidly( much faster than during the previous cycle) and are on the cusp of turning restrictive.

Chart 3: US FCI's have risen very rapidly and are on the cusp of turning restrictive.

Source: Refinitiv

The key cause for concern will be when the Fed are perceived to be 'slamming on the brakes' taking rates above the neutral rate

When rates are seen as above the neutral rate each incremental move is seen as creating significant headwinds for subsequent growth. Gauging neutral rates by measuring the ratio between consensus nominal GDP growth rates and terminal interest rate forecasts the US is now at neutral rate levels.

Any more tightening from here could start to be perceived a policy mistake.

Chart 4: US rates are already approaching 'neutral' levels

Source: Refinitiv

Index 15303321 E0922

Writer

Philip Lawlor

Managing Director,  Market Research (Benchmarks)

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