When Treasury Secretary Janet Yellen recently made the innocuous observation that the Federal Reserve might at some point have to increase interest rates to keep inflation in check, financial markets became so flustered that she had to revise her comments.
She was right the first time. I would go even further: Not only will the Fed have to raise rates, but rates are likely to go much higher than investors anticipate.
Markets expect short-term interest rates to remain very low for a very long time. Prices in the Eurodollar futures market, which has active contracts extending out into 2027, suggest that U.S. short-term rates will peak no higher than 2%. I see two reasons to believe this forecast is improbably low.
First, consider the “neutral” level for the Fed’s short-term interest-rate target — that is, the rate at which the central bank would be neither supporting nor braking economic growth. Judging from Fed officials’ latest economic projections, they think the rate consistent with 2% long-run inflation would be somewhere between 2% and 3%, with a median of 2.5%. This seems reasonable: It suggests an inflation-adjusted neutral rate of 0.5%, which is well below the long-term historical average of about 2%. And if history is any guide, the Fed will have to take rates considerably higher than neutral before its tightening cycle is done.
Second, the Fed’s new long-term policy framework implies even higher peak rates. The central bank has made it abundantly clear that it won’t start raising rates until inflation is expected to exceed its 2% target for some time — which, in my view, means it will probably have pushed the economy past maximum employment, and then will need to make monetary policy tight to cool the economy down. How far it must go will depend on what happens with inflation, which is difficult to predict with any precision. That said, it’s not hard to imagine the Fed taking its short-term target rate to 3% or even higher.
Why? Suppose inflation peaks at 2.5%. This would justify a slightly tight monetary policy — say, a Fed funds rate of 3.5% (1% in inflation-adjusted terms). But if inflation goes just half a percentage point higher, to 3%, policy presumably would need to be even tighter still. One could imagine a peak federal funds rate of 4.5% (1.5% in inflation-adjusted terms). This might sound very high, but only if you’re really young: During the tightening cycle that preceded the 2008 financial crisis, the federal funds rate peaked at 5.25%.
Short memories might be one reason markets haven’t priced in such high future rates: Investors are focused on the last business cycle, in which the federal funds rate never exceeded 2.5%. Another explanation is that Eurodollar rates are being held down by concerns that another shock could cut the recovery short and force the Fed to change course — as the pandemic did in 2020. I see such a recurrence as unlikely: The speed of the post-pandemic recovery, together with accommodative monetary and fiscal policy, will limit the opportunities for an adverse economic shock to interfere.
Years may pass before we’ll know whether I’m right. The tightening cycle will go through a several stages: talking about tapering assets purchases, actually tapering asset purchases, then finally raising the federal funds rate. Most Fed policymakers don’t expect the third stage to start until 2024 or later. I would expect sooner, as the economy bounces back faster than anticipated. But regardless of the precise timing, the Fed is likely to have to do much more than is currently anticipated. And that will create a more difficult environment for U.S. equity and bond markets.