Opinion: The bond market has a strong opinion on inflation, but what does it say about a recession?

Every time the Federal Reserve starts to tighten financial conditions, markets try to guess how far the central bank will go.

Indeed, now in an era where it provides its estimates of future policy in a framework known as “the dots,” the Fed itself is providing guidance on where the fed funds rate will land. For 2023 and 2024, the FOMC policymakers consider the median rate to be 3.375%; 4.375% is expected in 2023.

Several former Federal Reserve officials have also weighed in on what they think the policy should do. Alan Blinder, a former Fed vice chairman, has warned to go slow. Former Fed Governor Lawrence Lindsey has referred to the practice of making the fed funds rate exceed the rate of inflation as something that worked in the past. Judy Shelton, an economist once proposed to be a member of the Federal Reserve board, has mocked the Fed for not raising the rate to the rate of inflation like she used to.

But of all the comments that have been made, the most important is being made every day in the bond market. The fact that the 10-year bond yields TMUBMUSD10Y,
is trading lower, and currently below the 3% mark, it is a clear vote of confidence that inflation will not spiral out of control. With the fed funds rate in the upper 2.5% range today and 9.1% inflation in the consumer price index, only a fool would buy and hold 10-year notes yielding 3% or less if you thought inflation would last. . Clearly, the bond market doesn’t think so.

However, that does not make it perfectly clear what the bond market thinks.

Mud fight for the recession

Chris Waller and a co-author, and Larry Summers and his co-authors, are having a mud fight over the concept of whether the Fed can reduce inflation without having a recession, or at least a significant rate hike. unemployment

Waller, a Federal Reserve Board governor, would clearly like to argue that the Fed can raise rates and not necessarily plunge the economy into recession. That possibility would make the Fed’s rate-hike policies a little easier for the public and politically to digest. Summers and his co-authors take the opposite view that to reduce the rate of inflation, the unemployment rate must rise.

It is not clear that the bond market has a position on these issues. History clearly shows that inflation has only come down from very high levels after recessions. Those recessions have generally come after the Federal Reserve has 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 weapon in this debate. It just means that he has no history as his wingman.

‘Real’ Fed Funds Rate: A Red Herring?

Historically, it is true that the Federal Reserve has always had the fed funds rate higher than 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 down to a level of price stability.

Right now, with the rate of inflation so high and the fed funds rate so low, I don’t really know anyone who thinks we’re going to raise that rate above the rate of inflation or who really supports it. However, bond market behavior suggests that the rate of inflation is going to decline, and there may be a point in the future when the fed funds rate and the rate of inflation may have a more normal historical relationship. But are we going to get there by raising the fed funds rate or by triggering a recession first?

One of the things that I find most interesting is that few people at the Federal Reserve are willing to talk about this. In his last press conference, Fed Chairman Jerome Powell referred to the fed funds rate as finally reaching the position of being neutral. This is quite an impressive statement. In what sense is a rate of 2.5% neutral when the CPI is at 9.1%? I can’t begin to wrap my mind around it.

It may be that the Fed continues to think that much of the inflation is going to fade on its own. Remember that the entire tightening episode was delayed because the Fed said that inflation would be transitory. It strikes me that the Fed still has that belief but is worried about repeating that phrase because it already had to eat those words once in public and they didn’t taste very good.

However, CL.1 oil prices,
they have softened and there has been a solid change in commodity prices. The price indicator on the ISM manufacturing fell sharply in July. And there are reasons to think that some of the inflation is actually quite temporary and will more or less change on its own. The supply chain is being repaired. But wage inflation has picked up. Not all of the toothpaste will go back into the tube on its own; the Fed is going to have to scrape there using monetary policy. The Fed does not want to get involved in a discussion on this issue until there is good news on the table.

The bond market impresses me, in part because it has turned on the notion of controlling inflation at an early stage. I wonder how high the fed funds rate will have to rise before it starts to produce some results. The bond market suggests that it will not have to move very high at all. After that you will be alone.

I can appreciate 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 inverted.

Robert Brusca is Chief Economist for Economics at FAO.

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