MNI: Yield Spike Cuts Chance Of Fed Dec Hike, Q1 Still In Play

Sharply higher U.S. bond yields lower the chances the Federal Reserve will need to deliver a previously-projected final quarter-point hike for the fed funds rate this year, former Fed officials told MNI, though sustained above-trend growth could still prod the Fed to tighten next year.

The 10-year Treasury yield rose above 4% in August and touched 5% this month, its highest since 2007, as the economy grew well above trend in the third quarter and traders came around to the Fed's higher-for-longer message. Analysts have compared the bond yield surge to as many as three rate hikes and Fed officials suggested tighter financial conditions could substitute for additional tightening.

"If financial conditions are more or less what we see today by December, I think it’s plausible that the committee will skip the hike," said former Atlanta Fed President Dennis Lockhart. Twelve FOMC members penciled in a 25 basis point hike by the end of this year in the September Summary of Economic Projections, "but there’s nothing automatic about the final increase in 2023, and as things look today, it’s better than an even chance they could skip it."

GROWTH IMPACT

A new Fed index of financial conditions points to an intensification of the drag from overall financial conditions with more to come, said Eric Swanson, a former economist at the San Francisco and the Fed board who is now at the University of California at Irvine.

The index, known as FCI-G, includes the 30-year fixed rate mortgage, the BBB corporate bond yield, the 10-year Treasury yield, the fed funds rate, equity prices, house prices from the Zillow Home Value Index, and the Fed’s nominal broad dollar index. The measure omits lending standards or other non-price measures of credit availability, meaning it most likely understates financial conditions’ headwind to growth since March. The FCI-G uses economic modeling to predict how the change in financial conditions should affect year-ahead GDP growth.

The tightening in financial conditions since August should shave about a third of a percentage point off 2024 GDP and about a half point for 2025, said Swanson, who recently analyzed FCI-G along with former New York Fed markets chief Brian Sack. Swanson told MNI it's plausible the recent rise in long-term yields is equivalent to two or three Fed rate hikes.

"It's not that the financial markets are responding with a lag. It's that these interest rates that are going to affect the economy should be expected to affect the economy with a lag," said Swanson, who is expecting long-end yields to remain elevated persistently. "We estimate this sort of hump shaped lag response and that's because some of these interest rates affect the economy with a delay of a couple of months." (See MNI POLICY: Fed Convinced Past Hikes' Effect Still To Hit)

"That is enough to be slowing the economy down and bringing inflation back to target," he said. But if GDP growth this quarter remains above trend seen at about 2% then "that would indicate the need to put a little more downward pressure on the economy." The initial Atlanta Fed GDPNow model estimate for the fourth quarter was 2.3%. (See MNI INTERVIEW: Disinflation Stall Could Force Fed To 6% Or More)

TAKING IT SLOW

Stephen Cecchetti, a former research director at the New York Fed, said financial conditions are now close to sufficiently restrictive to bring inflation back to the Fed's 2% longer-run inflation goal but geopolitical forces are creating substantial uncertainty. "I would think that monetary policymakers will continue to take it slowly," he said. (See: MNI INTERVIEW: Blinder Sees Fed Rates At Peak For About A Year)

This final stage of the tightening cycle is a "tactical" period and the Fed will respond to developments, said Lockhart. "We’ve heard the argument that the Committee can hold off on any further hikes because markets are doing the work for them. While that's certainly true in the short term, that could change very rapidly."

"If things go badly geopolitically, a flight to the dollar and Treasuries will lower term yields. So it's not something they can treat as an ongoing substitute for policy actions," he said.