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

When the Federal Reserve begins to tighten financial conditions, markets try to guess how far the central bank will go.

Indeed, now in an era when it presents its estimates of future policy in a framework known as “points”, Itself It provides guidance on where the federal funds rate will fall. For 2023 and 2024, policy-setting FOMC members see an average rate of 3.375%; One expects 4.375% in 2023.

A number of former Federal Reserve officials have also pondered what they believe policy should do. Alan Blinder, a former Federal Reserve vice chairman, warned of the slowdown. Lawrence Lindsey, a former Fed governor, cited the practice of keeping the federal funds rate above the inflation rate as something that worked in the past. Jodi Shelton, the economist who once proposed for membership in the Federal Reserve, mocked the Fed for not raising the rate to inflation as it once did.

But, of all the comments made, the most important one is made every day in the bond market. The fact that 10 year bonds produce TMUBMUSD10Y,
2.779%
It is trading down to, and currently below that, the 3% mark is a clear vote of confidence that inflation will not spiral out of control. With the fed funds rate currently in a higher band of 2.5% and inflation at 9.1% on the CPI, only a fool would buy and hold 10-year bonds yielding 3% or less if they thought inflation would continue. Obviously, the bond market doesn’t think so.

However, that doesn’t quite explain what the bond market thinks.

Mud fight on slack

Chris Waller and co-author, Larry Summers and co-authors, are fighting a muddy battle over the concept of whether the Fed can cut inflation without a recession, or at least a significant rise in the rate of unemployment.

It is clear that Waller, a conservative at the Federal Reserve, wants to demonstrate that the Fed can raise interest rates and not necessarily push the economy into recession. This prospect should make the Fed’s rate hikes a little easier to swallow for the public and politics. Summers and colleagues take the opposite view that to lower the rate of inflation, the unemployment rate must rise.

It is not clear whether the bond market has a position on these issues. History clearly shows that inflation has only fallen from very high levels after recessions. These recessions generally came after the Federal Reserve raised interest rates significantly. History has not yet produced a situation in which interest rates rise and inflation declines significantly without a recession. This does not mean that Waller will not be the best in this debate. It just means that he has no history as his wing bird.

‘Real’ Fed Funds Rate – Is It A Hoax?

Historically, it is true that the Fed has always had the federal funds rate above the rate of inflation whenever a recession began. However, this was true even in the recessions that started and ended and that failed to bring the inflation rate down to the level of price stability.

Right now with inflation so high and fed funds rates so low, I don’t really know anyone who thinks we’re going to raise that rate above inflation or who will actually endorse it. However, the behavior of the bond market indicates that the rate of inflation will decline, and there may be a point down the road where the federal funds rate and the inflation rate can have a more natural historical relationship. But will we get to that point by raising the Fed funds rate or by stagnating first?

One of the things I find most interesting is that few people at the Federal Reserve are even willing to talk about this. At his most recent press conference, Federal Reserve Chairman Jerome Powell indicated that the Fed funds rate has finally reached the neutral position. This is an amazing statement. In what sense is the 2.5% rate neutral when the CPI is running at 9.1%? I can’t turn around that.

The Fed may continue to believe that a lot of inflation will go away on its own. Remember that the entire tightening episode has been delayed by the Fed saying that inflation will be temporary. It amazes me that the Fed still has that belief but is worried about repeating that phrase because it actually had to eat those words once in public and it just didn’t taste good.

However, CL.1 oil prices,
+ 1.44%
It eased, and there was a strong shift in commodity prices. The ISM manufacturing price gauge fell sharply in July. And there are reasons to believe that some inflation is in fact entirely temporary and will shift somewhat on its own. The supply chain is fixed. But wage inflation rebounded. Not all toothpaste will return to the tube on its own; The Fed will have to dump it there using monetary policy. The Fed doesn’t want to get into a discussion about it until some good news is on the table.

I like the bond market, it’s a party because it threw a lot of the idea of ​​controlling inflation at an early stage. I wonder how far the fed funds rate has to go up before it starts to produce some results. The bond market is indicating that it will not have to move very high at all. After you are on your own.

I can appreciate the argument Waller is trying to make, but if I had to take one side, it would be with Summers, who is looking for slack. This is because stagnation stops inflation. And I think that’s what the bond market knows and why the yield curve is inverted.

Robert Bruska is the chief economist for the economics of the Food and Agriculture Organization.

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