Did Goodhart strike back in the U.S?

Fed has maintained policy rates at 0-0,25% for many months

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, thinks there’s some of this going on in the US. For last year, the Fed shifted its monetary policy to target a higher level of inflation because it seemed that inflation was dead. But not only is it not dead, but it is also very much alive and kicking. You might have thought that financial markets would project that the Fed will have to get tough to tackle this ‘misbehavior’ but that’s not the case.

If you look at the eurodollar futures strip, it shows rates rising from around 0.2% now to around 1.75% over the next two years, or so, and, at that point, rates flatten out. Hence the market is suggesting that, despite this enormous inflation problem at the moment, with PCE prices rising at 5% and the CPI up at 6.8%, the Fed will be able to get away with probably little more than 150-bps in rate hikes over the next couple of years.

This seems optimistic on a couple of levels. The first is that it does not imply that monetary conditions, or at least those monetary conditions dictated by the level of policy rates, will become restrictive. For if we assume that the Fed is successful in bringing inflation back to the 2% target, which seems a big ‘if’ at the moment, the real (inflation-adjusted) fed funds rate will still be below zero. In the past when the Fed has tightened policy, it has had to take the real fed funds rate up to positive levels and we don’t see why it should be different this time. Of course, monetary conditions can be tightened in other ways, via higher bond yields, for instance, perhaps sparked by a Fed decision to shrink its balance sheet aggressively. But even so, we find it hard to believe that this, when allied to a still negative real fed funds rate will be sufficient to slow the economy enough to eradicate the inflation risk. Another point is that the Fed’s own definition of the ‘nominal’ neutral rate is currently 2.5% and the market is clearly not priced for the fed funds target to get near this level. Perhaps that’s inspired by FOMC members themselves. For their median forecast for the fed funds rate at the end of 2024 is still only 1.75% with some members (4) even predicting that rates won’t get above 1% by this stage.

Investors might also remember the last tightening cycle that ran from 2015 through 2018 and saw the fed funds peak at the 2.5% level that the Fed currently defines as the neutral rate. But, back then, there was some criticism about the level to which rates rose and not just from President Trump. The fact that policy rates were coming down before Covid struck may also serve to suggest that a positive real fed funds rate in the coming years could represent a similar over-tightening of policy.

Another factor that might embolden investors’ hopes for a modest tightening cycle is that private forecasters appear to be projecting rates to rise by similar levels to the Fed. For instance, the median call of the fifty-plus analysts in the regular Bloomberg poll puts the Q4 2023 fed funds rate at 1.3% which is only around one rate hike more than the 1% forecast that the FOMC currently predicts for the end of 2023. Hence it does not seem that analysts think the Fed is slipping behind the curve and the market itself, as reflected in eurodollar futures certainly does not.

In other words, few seem to think that ‘Goodhart’s law’ is going to be an issue as the overshoot in inflation will be contained not just by modest monetary tightening, but even more modest tightening than we’ve seen in previous cycles – even though inflationary pressure seems far greater now. Call us cynical, but this seems to us to be a scenario that is far too optimistic.

“In our view, one of two things is more likely. The first is that the Fed will have to tighten by far more than currently priced into the market to push policy into a restrictive position. The second is that the Fed remains shy of more aggressive hikes but this prolongs the bout of inflation and tips financial assets into a steep decline. Admittedly, this may help justify current forecasts for the persistence of relatively low policy rates but only at a cost of much weaker growth. Either outcome appears challenging for investors”, Mr. Steve Barrow said.