MNI INTERVIEW: Fed Not Done Hiking Despite Bank Pain-Cecchetti

The Federal Reserve will need to raise interest rates further to ensure that inflation returns to its 2% target, but financial sector turmoil will probably flare again, tightening financial conditions and keeping the rate cycle peak lower than otherwise, former BIS advisor and New York Fed staffer Stephen Cecchetti told MNI.

“I think they still have to go somewhat higher. Will the peak be lower than before the problems that cause? Probably yes, they will be lower but they probably will have to go a bit higher,” Cecchetti told MNI’s FedSpeak podcast, noting that inflation will likely prove more persistent than policymakers expect.

But rate hike expectations retreated sharply after the banking crisis and the market briefly priced in a pause before returning to the expectation of one more increase in May. The Fed raised rates by a quarter point last month to a range of 4.75% to 5%.

TIGHTER FINANCIAL CONDITIONS

Cecchetti, a professor at Brandeis University, warned against viewing the meltdown in banks as resulting from a monetary policy error, arguing instead that reducing credit availability is the goal of interest rate hikes.

“What the Fed is trying to do is tighten financial conditions. Financial conditions can tighten with or without interest rate increases. They’ve tightened quite significantly in the last three weeks. Will they continue to tighten without the Fed raising rates? I don’t think so.” (See MNI INTERVIEW: Small, Midsize Credit Seizing Up-Kaplan)

Inflation is likely to remain elevated despite the possible credit retrenchment, in part because of a red-hot labor market where the number of jobs open far exceeds that of available workers.

“I think inflation is going to come down much more slowly than the FOMC is currently projecting. My guess is we’re going to be lucky to have inflation at 3.5% at the end of this year. Some members of the FOMC have suggested that it could go down lower than that but I’m not so sure,” Cecchetti said.

The Fed’s March forecasts peg year-end inflation at 2.7%, then see it falling to 2.3% by the end of 2024.

“I think we’re going to be lucky if inflation is below 3% by the end of next year,” Cecchetti said. “I think inflation will prove to be sticky, it will prove to be persistent. The question in my mind is whether policymakers will have the resolve to actually keep policy tight for long enough to bring inflation down.”

He noted real rates are finally positive after the Fed jacked them some 500 basis points higher over the last year – “but that’s taken quite a while.”

MORE LOSSES LURK

Cecchetti, who as part of his BIS role was involved in the post-2008 financial crisis reforms, said risks remain both within and outside the traditional banking system.

“I don’t think (the crisis) has passed, the question is what has not passed and what are we looking forward to,” he said.

“When interest rates go up there are capital losses on fixed income securities. Whoever is exposed to them is going to take those losses. Those losses are going to be fairly large.”

He said looking at the USD25 trillion Treasury market alone, these unrealized losses could add up to trillions of dollars.

“The duration of that stuff is probably about six years. What that duration number means is that a one percentage point increase in interest rates is going to generate something like a five to six percentage point decline in the value of those securities. That’s a lot, so for each percentage point you’re getting USD1.25 trillion in capital losses somewhere,” Cecchetti said.

“Am I worried about that? Yes. Who is it that’s holding that? I don’t know. That worries me that I don’t know. Is it insurance companies? Is it pension funds? Those people may be able to withstand those? Is it other nonbank intermediaries? Maybe it is.”