If the CPI comes in at 8.0-8.5%, we expect that the Fed will increase the Fed Funds Rate by 75 basis points at its FOMC meeting on July 26th and 27th.
If the CPI is 9.0% or greater, we expect the Fed will increase the Fed Funds Rate by 100 basis points.
If the CPI is between 8.5-9.0%, it is anybody’s guess as to whether the Fed will increase by 75 or 100 basis points.
Why do we expect June’s CPI figure to come in modestly higher than May’s 8.6% reading? Despite the fact that some real world measures such as housing have cooled, the data collected by the Federal Government is reported with a lag. Therefore, CPI readings are far removed from real-time information.
Where should the Fed Funds Rate be? The Fed ought to have its Fed Funds Rate approximately in-line with the 2-Year Treasury yield which stood at approximately 3.12% as of Friday July 8th.
What do we view as a neutral policy rate? We would answer that question with a question. If your time frame is today (i.e. t = 0), the neutral rate ought to equal the present CPI reading (approximately 9%). If your question is: “Where will the neutral rate be two years from now?”, we believe it should be in-line with the CPI reading two years from now. We expect the CPI to read approximately 4% two years from now.
Why doesn’t the Fed simply get aggressive as former Fed Chairman Paul Volcker did in 1980 and take the Fed Funds Rate to double-digit percentage territory? The Federal Government/Treasury could not afford to pay the interest expense on the Federal Debt outstanding (approximately $30 trillion outstanding), if the Fed were to take interest rates into high single-digit percentage territory, nevermind double-digit percentage interest rates. We would not expect the Fed to take the Fed Funds Rate higher than 4%.
Do we expect yields to climb higher? Yes. Yields will climb higher as the Fed reduces its balance sheet of positions in Treasuries and Government Agency securities (known as “QT”), combined with increases in the Fed Funds Rate.
QT: It should not be lost on investors that the Fed is transitioning from its role as the world’s largest buyer of Treasuries and Government Agency securities to that of the world’s largest seller. Selling Treasuries and Government Agency securities pushes yields higher, which is a headwind for equities and risk assets in general.