Discussion
Former FRB New York President Bill Dudley is a key channel for non-official FED communication, and his Bloomberg op-ed this morning is just the latest in a string of evidence that the Fed is re-hawking. Big time. I first flagged the possibility a hawkish move was coming in a Fed Watch piece on June 26, and that possibility was subsequently confirmed by Roger Ferguson two days later when he put three more hikes on the table for the remainder of 2023.
Dudley’s op-ed contained three key pieces of information:
The Fed is in the process of raising its long-run “neutral” rate projection
Inflation is likely to average 2.5% over time, not 2%, as the Fed’s reaction function is asymmetric
The 10-year Treasury note yield is likely to rise to at least 4.5%
Long-Run “Neutral” Rate
“They also appear to be increasing their estimate of the “neutral” rate that neither restrains nor boosts the economy, suggesting that a higher fed funds rate will be required to combat any given level of inflation. This makes sense: With baby boomers spending down retirement accounts, the government running large budget deficits and vast capital investments required in supply chains and green technology, higher rates will be necessary to balance demand for borrowing with a shrinking supply of savings.”
Dudley’s comments about the long-run “neutral” rate are no accident. As I detailed in a May 17 Twitter thread, FRB New York President John Williams gave an impassioned Q&A talk about the importance of the 2% inflation target and the fact the Fed will not allow “structural” factors to keep inflation well above the Fed’s target.
The Fed is shifting its tightening program to the third and final phase: “higher for longer”. Pay attention.
2.5% Average Inflation
“…over time, average inflation will almost certainly be higher than the Fed’s 2% target. The central bank’s monetary policy framework is asymmetric. When inflation is too low, it wants to compensate by aiming above 2%, lest inflation expectations decline and erode its ability to stimulate growth. But when inflation is too high, Fed policymakers merely aim to get back to the 2% target. Over time, the result should be more upside than downside misses.”
This is a soft raising of the inflation target, but it is NOT dovish until the Fed gets inflation back to 2% and can begin thinking about stimulating. The Fed is very much laying the groundwork here for “higher for longer”.
4.5% 10-Year UST Note Yield
“Suppose the Fed’s short-term interest-rate target, adjusted for inflation, averages about 1% over the next decade. Inflation averages 2.5%, and the bond risk premium is one percentage point. In sum, this suggests a 10-year Treasury note yield of 4.5%. And that’s a conservative estimate: Given historical neutral short-term rates, the recent persistence of inflation and the troubling US fiscal trajectory, all three elements could easily go higher.”
A 4.5% target is no accident. FRB Minnesota President Neel Kashkari outlined the case for a 2% TIPS 10s yield in an essay last June 17, and Dudley’s math just so happens to result in exactly 2% (4.5% nominal - 2.5% inflation).
The Fed is re-hawking in a major way, and very importantly the bond market is confirming. Now let’s see if equity and credit markets allow the Fed to follow through…