Investors are increasingly betting that the Federal Reserve will have to raise interest rates sooner than previously expected to keep inflation in check. A few months ago, futures prices implied that “liftoff” from the current near-zero level wouldn’t occur until 2023 or later; now they suggest it’ll happen near the middle of next year.
There hasn’t, however, been a similar shift in how high investors expect interest rates to go. Markets still see a peak in this business cycle of less than 2%. I think there’s a good chance they’re mistaken.
Let’s start with the Fed’s own perspective. As of September, officials estimated that the “neutral” federal funds rate — the rate consistent with the central bank’s 2% inflation target — would be between 2% and 3%, already higher than market expectations. But under its new monetary policy framework, the Fed intends to allow inflation to rise above 2% to make up for previous downside misses. If, say, inflation went to 3%, the neutral rate would be 3% to 4% — and the Fed would eventually have to raise interest rates significantly higher than that to make monetary policy sufficiently tight to bring inflation back down to its long-term target.
History also implies a considerably higher peak in interest rates. The lowest peak on record — between 2.25% and 2.5% — occurred during the last expansion, which was very different from the current one. First, the pandemic cut the last business cycle short, which was one reason why the Fed had no inflation problem to combat. Second, the economy faced significant headwinds — including collapsed home prices and restrictive fiscal policy — that don’t exist this time around. Finally, financial conditions were a lot less accommodative than they are now: The stock market has been hitting record highs, bond yields are unusually low and credit spreads are very narrow.
