Why The Fed Will Keep Rates Above 4% For A Long Time

Higher for longer. That’s what numerous Federal Reserve officials have been saying about interest rates for some time. Nonetheless, many investors don’t take them at their word, and expect the central bank, sooner or later, to “pivot” and reduce short-term rates a lot, once the inflation beast is conquered.

Fed Vice Chair Lael Brainard recently cautioned the public that rates would have to stay on the high side for some time to ensure that inflation indeed is on the decline. Yes, inflation is cooling, as the Consumer Price Index report for December indicates: sliding to 6.5% annually, from 7.1% the month prior. Nonetheless, 6.5% is higher than the CPI has been in four decades. There’s no rule that guarantees that, if inflation is going down, it will continue to decline. It needs some help from the Fed.

“Even with the recent moderation, inflation remains high, and policy will need to be sufficiently restrictive for some time to make sure inflation returns to 2% on a sustained basis,” Brainard said in a speech in Chicago. Not long ago, inflation was well below 2%, and rates were near zero.

Right now, the federal funds rate, the benchmark that the Fed controls and uses to steer the economy (or to try to), hovers between 4.25% and 4.5%. What’s widely expected, and telegraphed by the Fed, is that the bank’s policymaking body will push up rates just a quarter-point when it meets Wednesday. That’s a slowing from the Fed’s more aggressive effort last year, when it issued four consecutive hikes of 0.75 point each.

Now, the Fed doesn’t want to stay that gung-ho, for fear of tipping the economy into a recession. So lighter increases, like the one expected tomorrow, make more sense—and suggest to some that we are near the end of its tightening regime.

The futures market projects that the benchmark will be in a band of 4.75% to 5.0% by July, which implies one more quarter-point rise after the February meeting. By December, however, the betting is that the fed funds measure will be back down to 4.5% to 4.75%. In other words, that the Fed will start to ease this year.

A month ago, the futures markets believed that the Fed would enact a half-point hike at the February meeting. So you can see the shift in perceptions about where the Fed is headed.

But odds are this prognostication is flat wrong. The Fed has its own internal poll of members, called the dot plots, which find that the members feel the year will end up with the rate at around 5.0%. They also think it will go down, just not soon and by much—around 4.0% at the end of 2024.

Another, seldom mentioned aspect of the Fed’s campaign is to “normalize” rates. And rates near zero, done in response to the onset of the pandemic, are not normal. Before that, though, rates were still far, far too low. Since the 2008-09 financial crisis, they were under 2%, sometimes below 1%. That encouraged all kinds of distortions in the economy, such as a rush into stocks, which led to their over-valuation.

The truth is that the best place for short-term rates to be is in the 4% to 5% range. That’s where they were in the 1990s, when the economy was booming. It managed to so without the artificial stimulus of near-zero rates. Betcha that’s what the Fed has on mind for the future. Investors should be aware of this reality.

Source: https://www.forbes.com/sites/lawrencelight/2023/01/31/why-the-fed-will-keep-rates-above-4-for-a-long-time/