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Risk of another taper tantrum this year
The Federal Reserve may need to raise interest rates to at least 3.5% and perhaps even above 4% because its new framework will generate lags in responding to inflation that require more aggressive tightening later, former New York Fed President William Dudley told MNI.
"The chance of a soft landing in this regime is virtually nil," Dudley said. "They're going to be late and that's by design. So when they start tightening they're going to have to go relatively quickly."
When the Fed does eventually begin to raise interest rates it will have to keep doing so for some time Dudley said, much like during the "considerable period" phase under Alan Greenspan from 2004-2006.
Dudley is surprised markets are only pricing in a rise in the federal funds rate to 2% because "that's lower than what the Fed says is neutral."
His views are much bolder than the Fed's Summary of Economic Projections that suggests no rate increase perhaps until 2023 and a long-run rate of no more than 2.5%. Markets are also betting on modest Fed rate increases with a 0.86% yield Friday on five-year Treasury bonds.
HEADING TO FULL EMPLOYMENT
The Fed announced changes to its policy framework last August that include seeking a modest overshoot of its 2% inflation target to make up for past misses and promising not to tighten monetary policy until a much more inclusive definition of full employment is achieved.
The economy is "probably going to be pretty close to full employment probably as early as next year," Dudley said, unlike the recovery from the Great Recession that took over a decade. That's in part because household balance sheets have been aided by strong fiscal and monetary relief.
"There's still going to be a pretty healthy balance sheet going into 2022," he told MNI. "The health of the household balance sheet for the 120 million Americans who have been employed through most of this period is important."
The Fed will have to lean against an economy that might be looking too hot at some point and history suggests this ends in retrenchment as the central bank is forced to overreact, Dudley said.
"Policy will have to be made tight to keep inflation from continuing to climb," he said. "Once things start to deteriorate there's a feedback loop."
TAPER TANTRUM RISK
Fed Chair Jerome Powell reiterated a message of ongoing patience in the face of stronger economic data at this week's meeting. MNI has reported the Fed is edging closer to the parameters it has set for reaching "substantial further progress" toward its goals, but a lot more job gains will be needed before then.
The central bank has been buying USD120 billion per month since the start of the pandemic, pushing its balance sheet to a record USD7.7 trillion.
The risk of a market disruption like the 2013 "taper tantrum" is fairly high when the Fed does signal it is getting closer to reducing QE, Dudley said.
"There's going to be some kind of market event this year when the Fed tries to signal there will be a transition," he said. "No matter how gentle you try to be, we are still moving into a different regime."
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