All METARs know that the fed funds rate is critical to the markets and that the Federal Reserve is in a rising rate cycle. The Fed has announced that it wants to bring the fed funds rate to a “neutral” rate which neither stimulates nor slows the economy. Any fed funds rate below inflation is a negative real rate which pays borrowers to borrow. Today’s fed funds rate of 3% is well below the inflation rate.
The history of the fed funds rate shows that holding a neutral fed funds rate for a long time, with only minor tweaks to discourage inflation, led to a growing economy from 1995-2000. The fed funds rate was about 5.5% and inflation was roughly 2.5 to 3% so the real fed funds rate 2.5% to 3%.
However, after the dot-com crash and mild recession of 2001, the Fed adopted a policy of cutting the fed funds rate extremely low and holding it long past the crisis had resolved. This addicted the markets to negative yield money.
Every time the Fed tried to raise rates, the markets reacted badly. The Fed hardly tried to hold rates steady before dropping them.
Now the markets are conditioned to expect the Fed to cut rates every time there is a whiff of inflation receding even a little bit. The market reaction (dropping the yield of the 10 Year Treasury overnight) is making the Fed’s job more difficult since the market’s moves are stimulative.
The message from the Fed – that they may slow the pace of rate rises – is being interpreted by the markets that the Fed will only hold the higher rate for a short time before lower it … because that’s what they did in 2000, 2007 and 2019.
But the Fed is trying to get out the message: Slower isn’t lower. Even if they slow the pace of rate increases, they will continue to increase until inflation recedes to their target. And then they will hold it, even if a recession results, until they are sure that inflation will not increase. Which may be a long time, if they judge that the rate is the neutral rate they have been seeking.
The markets are acting the way they did in June 2022. The warnings from the Fed are coming from several directions. The message is clear: Don’t fight the Fed. Slower isn’t lower.