The bubbles in the asset markets began in 2000 when the Federal Reserve began to suppress the fed funds rate in response to the dot-com bust and a mild recession. They blew sequential bubbles by suppressing the fed funds rate below inflation in 2000-2004, 2010-2016 and 2020-present.
https://fred.stlouisfed.org/series/FEDFUNDS
With inflation raging, the Fed has promised to return the fed funds rate to neutral, a rate that will neigher stimulate nor depress economic growth. But what is neutral? If the fed funds rate is lower than inflation, the real rate will be negative.
https://wellsfargo.bluematrix.com/links2/html/037c5b94-4f79-…
**Wells Fargo Economics**
**June 6, 2022, by Jay H. Bryson, Sarah House, Michael Pugliese**
**June Flashlight for the FOMC Blackout Period**
**...**
**We think the year-end 2022 median [Federal Reserve committee] dot [plot of expected interest rates] will be 2.875% or so, which would put the fed funds rate modestly above neutral by year-end and in line with our own forecast. The current median dot for 2023 is 2.75%, and we expect this to shift higher to 3.375% or so. This would signal more tightening at the margin while also striking a balance between some of the more hawkish and dovish FOMC participants. For 2024, we expect the median dot to be largely unchanged from March's 2.75%....[end quote]**
Unless inflation declines to about 3% by the end of the year, these fed fund rates will still be negative. A fed funds rate of 3.375% would make the yield curve negative unless the entire curve lifts. If the entire curve lifts, trillions of dollars of existing bond value will evaporate.
Wendy
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Why would the FED even raise rates at all? Isn’t the market doing that all by itself? Look at mortgage rates that have seen an increase of over 200bp without any FOMC intervention. As inflation rises, money moves out of fixed income assets (US Treasuries). As a result yields rise and then so do mortgage rates. This has already happened, so again, why the FED intervention? The housing market is in for an adjustment, and when that happens, demand will fall. As in history, the FED will overreact and push us needlessly into a recession.
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Why would the FED even raise rates at all? Isn’t the market doing that all by itself? Look at mortgage rates that have seen an increase of over 200bp without any FOMC intervention. As inflation rises, money moves out of fixed income assets (US Treasuries). As a result yields rise and then so do mortgage rates.
The rise in interest rates is a complicated phenomenon that is in part caused just by rising inflation, but also by the Fed’s credible commitment to raising its overnight rates and to switching from quantitative easing (QE) to quantitative tightening (QT). The Fed’s overnight rates don’t directly effect mortgage rates or other longer term interest rates, but it does have some influence as short term rates rise, longer term rates must as well to stay competitive.
QT affects longer term interest rates directly by removing the Feds buying of billions of dollars of bonds and other instruments, including mortgage backed instruments, allowing the price to incrementally drop and interest rates to rise. The credible promise that this will be ongoing for the foreseeable future causes interest rates to react more than the loss of immediate buying does.
As a result yields rise and then so do mortgage rates. This has already happened, so again, why the FED intervention? The housing market is in for an adjustment, and when that happens, demand will fall. As in history, the FED will overreact and push us needlessly into a recession.
The economy is still running hot, with a very tight labor market driving ongoing wage inflation and other contributions to overall inflation. I don’t think many people believe the Fed has already done enough to stop inflation, in fact very many people believe they are behind the curve and we are at risk of inflation expectations becoming embedded in the economy which would make reducing inflation all the harder.
No doubt the Fed has a hard task trying to break inflation without causing a recession, but recessions are a normal part of the economic cycle and we can expect the Fed to be quick to change gears when it’s clear they’ve done enough … though as you note it may be later than ideal, I don’t envy their job and think they are correct to continue tightening for now.
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