Monetary policy comes with a sizable lag. Unfortunately, policymakers are often slow to recognize early signs of weakness, waiting instead for a definitive change in the numbers that unequivocally convinces them that the economy has moderated enough to warrant a pause in further adjustments.
At such a point, however, it is too late and the irreparable damage to the recovery has been done. In other words, officials are inclined to continue tightening longer than is necessary instead of taking a pause to assess the impact of earlier rate hikes and allowing the data to catch up.
{mosads}At this point, the slowdown may already be occurring under the surface with some of the economy’s most interest rate-sensitive sectors, such as housing, raising red flags of inflation beginning to slow.
Yet, the Federal Reserve seems convinced further action is still needed after eight rate hikes in three years. The Fed appears willing to raise rates past the longer-term neutral level. This is arguably how expansions end.
Earlier this month, in the aftermath of the September rate hike, Fed Chairman Jerome Powell perpetuated the notion of further Fed action to come. Speaking Oct. 3, Powell indicated he continues to view current levels of rates as “accommodative.”
On Wednesday, the release of the September Federal Open Markets Committee meeting minutes reaffirmed the committee’s willingness to push forward with additional policy action in the near-term.
Moderating prices: A tale of disinflation
The apparent theme of disinflation has been well established in the past several months. Despite the implementation of tariffs, global weakness has seemingly trumped (no pun intended) the fear that additional levies would skyrocket the cost of consumer goods. The market, however, like the Fed, has yet to accept the slowing pace of inflationary pressures.
Despite the lack of runaway inflation, however, the Fed has positioned itself as the slayer of the proverbial inflation dragon lurking around the corner. Even now, with inflation abating, the Fed continues to affirm the need for additional rate increases to neutral, and beyond, to combat the fear alone of rising prices.
Nevertheless, as the Fed continues to cry inflation, the market has jumped on the bandwagon, pushing rates to a multi-year high.
Market reaction: Buying what the Fed’s been selling
For much of the second and third quarters, the yield on the 10-year Treasury bond was trading in a tight range of 2.73-3.11 percent. As the fourth quarter began, however, rates broke to the upside with economic data seemingly poised to continue to support robust growth, particularly amid record-low unemployment.
The recent backup in domestic yields, however, has more to do with monetary policy than domestic fundamentals. After all, not all areas of the economy are signaling full speed ahead; activity for interest rate-sensitive sectors such as housing and car purchases is trending lower.
Instead, much of the rise in longer rates is the realization, or perhaps acceptance, of a likely more accelerated path of rates amid a still-solid economy or even a fear the Fed will not be able to hike fast enough.
In other words, the bond market has awoken to the notion of a potentially faster pace of Fed action — warranted or not — and bought into the Fed’s message of faster future inflation. Inflation expectations, after all, while still fairly muted, have risen modestly over the past year.
This newfound faith in the Fed’s outlook, however, will presumably dissipate in the face of a more dismal reality of waning inflation and slower growth. The former, of course, is already evident in the latest inflation reports and the latter is likely to become more apparent sooner than later.
As we’ve seen in the past, rates typically back up toward the end of the Fed’s tightening cycle as policymakers continue to forecast a need for additional action. But as the signs of weakness become more evident — at least to market participants — yields fall.
Fed officials, however, are usually the last to the party in terms of recognizing that rate hikes work with a considerable delay, ignoring initial signs of waning momentum in lieu of clear signals that the expansion has come to an end.
At that point, it is too late and a different demon — the inflation dragon’s ugly cousin, recession — is leering around the corner.
Rather than pinpointing the precise level of rates, the Fed’s focus at this point is to navigate a soft landing for the U.S. economy — raising rates enough to eliminate the fear of an overheating economy but not so much that the Fed squeezes the economy into recession.
Fed policy, however, comes with a considerable lag and, like policymakers before them, the current committee doesn’t appear to have the patience to wait and assess the impact of previous rate increases before moving forward with additional adjustments.
Market participants will be the first to recognize early signs of weakness already brewing under the surface of the U.S. economy.
Such subtlety, however, will no doubt be lost on most Fed members, as, according to Powell, the Fed may be gearing up for a December rate hike and several more in 2019, unaware or unable to diagnose waning inflation and more broadly, deteriorating conditions until it’s too late.
Historically, the Fed typically overshoots. Brace for history to repeat itself.
Lindsey Piegza, Ph.D., is the chief economist for Stifel Fixed Income. Her research has been published in the Harvard Business Review and in textbooks for Northwestern University’s Kellogg Graduate School of Management. She’s a regular guest on CNBC, Bloomberg, Fox News and CNN.