MNI INTERVIEW: Fed Likely Needs To Do More - Ex-Fed's Giannoni

Strong U.S. economic data will likely force the Federal Reserve to raise interest rates again as policymakers realize higher long term bond yields cannot be relied upon to do the job of sufficiently tightening financial conditions and slowing demand, former Dallas Fed research director Marc Giannoni told MNI.

The yield on 10-year Treasuries has fallen some 40 bps since hitting a 16-year high of 5% late October in the lead up to the latest FOMC meeting where Chair Jerome Powell said persistently tighter financial conditions could matter for future rate decisions. Stocks and bonds rallied on expectations the Powell was hinting that the Fed was done hiking.

"Because long term yields are so volatile, you can’t rely on them to exert the drag on the economy that you would need on a long term basis, and we saw that in the past week," Giannoni, now at Barclays, said in an interview. "It’s like the dog chasing its own tail when they talk about financial conditions, but by doing that they ease conditions."

The FOMC fears overtightening and is looking for confirmation that the economy is slowing. "They don't want to overdo it, so they're being more prudent," Giannoni said. "I'm concerned it might not be enough."

Powell said in remarks at the IMF Thursday the Fed is not yet confident monetary policy is sufficiently restrictive to bring inflation back to 2% in a timely manner.

WISHFUL THINKING

The FOMC's November 1 characterization of how the U.S. economy has been performing downplayed strong growth in the third quarter and a resurgence of strength in the labor market in the summer, Giannoni said. September's job gains were the second highest this year, while GDP expanded at the fastest rate since 2021.

A new reference to tighter financial conditions in the statement, as well as Powell's conviction during last week's press conference that the recent rise in bond yields was driven by higher term premia rather than expectations for the policy path, also sent dovish signals, Giannoni said.

Yields have since come down some 40 basis points from their peaks, a retracement that shows the dovish shift in market expectations, Giannoni said. "The market removed some probability of rates moving further up from here. That's reflecting in the pricing."

Models mechanically attribute fluctuations in long term yields to term premia, and that might not be the right interpretation, he said. If underlying policy is the driver, then the Fed needs to follow through. Additionally, if growth is 5%, it could also mean the entire structure of rates should be higher to suit a robust economy. (See: MNI INTERVIEW: 2024 Fed Hikes Possible On Fiscal Boost-Kaplan)

"A fairly persistent rise in bond yield could be worth several quarter point hikes. But if the economy is stronger and demand stronger, to keep inflation in the same place, you’d need a higher term structure of rates, including at the short end."

SUSTAINED INFLATION

What the FOMC doesn't know is how sticky inflation will be next year, and its risk management strategy would call for another hike to balance the larger cost of too-loose policy, Giannoni said. (See: MNI: Fed's Barkin Sees Sticky Inflation, Policy Lags)

"I continue to assume data will come in resilient, and at some point they’ll say inflation is not coming in as expected and will decide to hike," he said. The weaker than expected October jobs report is just one soft print in a string of strong reports, he noted. "Hiring rates are still elevated. Firms still want to add jobs."

If core PCE inflation settles closer to 3% next year, the Fed would have to act aggressively. "Six months from now, it will be several hikes rather than just one. The cost of being a little too loose now is larger than too tight."