The Federal Reserve may raise the funds rate by 0.5 percent at its May meeting.

The answer is that policy will have to be tightened until financial conditions are sufficiently taught to bring demand down to match the constrained supply we are seeing in goods, services and labour markets. But note the key is that we are talking about financial conditions, which is not the same as the fed funds rate. A high fed funds rate can occur alongside tight financial conditions but often it is the other way around; financial conditions are tight when policy rates are low, such as we saw in the early stages of the pandemic.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said: “Our concern is that financial markets might not help deliver the scale of tightening in financial conditions that’s required to bring inflation back to target. Put another way, we suspect that the key components of financial conditions, such as bond prices, equities, corporate credit spreads, the value of the dollar and more will all have to move considerably from current levels to calibrate financial conditions appropriately”.

Financial conditions have tightened over the past month. But financial conditions still appear very loose, particularly given that the market is now priced for the Fed to take the FED funds target to over 3% and sell somewhere over USD 1 trillion per year of bonds under quantitative tightening. To effect a slowdown in demand financial conditions will have to tighten further. Increases in fed funds rates are a key component of tighter financial conditions but are not sufficient. The mortgage market, for instance, runs off long-term rates and hence these have to go up quite a bit to cool mortgage demand. Equities are important as well because the vast build-up in household wealth since the financial crisis has been in stocks (not housing as it was before 2008). Hence, to effect significant wealth effects and so constrain demand, it seems likely that tighter financial conditions will have to involve some sort of equity weakness, whether that’s a sudden plunge or a protracted period of weakness.

“We think an added reason why tighter financial conditions will be needed this time around is that the labour market may be unable/unwilling to do any of the adjustment. Usually, policy tightening sees the unemployment rate rise and this depresses sentiment so reinforcing the slide in growth. But the labour market is a very strange animal in the wake of Covid. It is extremely tight and issues such as the dearth of skilled labour may mean that the unemployment rate rises very little, if at all, as policy tightens. The FOMC, for one, forecasts that the unemployment rate will not rise in coming years. If the labour market can’t do the heavy lifting in terms of bringing demand down to meet restricted supply, then more will have to be done through financial conditions, which is another way of saying that asset prices are at greater risk”, Mr. Steve Barrow stressed.

The bottom line, Mr. Steve Barrow’s view, is that financial conditions will have to be much tighter in the next year or two than they are now to effect the slowdown in demand required to bring inflation back to target. This tightening in financial conditions could occur because the Fed has to push rates hard– until the pips squeak– so to speak, to effect lower asset prices, particularly in bonds. Alternatively, of course, financial conditions could tighten sharply without aggressive Fed action. Negative shocks such as the pandemic or the Russian invasion of Ukraine can do this.

However, the quick recovery in financial conditions after such shocks suggests that this may not be sufficient and, in the end, it may well require the Fed to go well beyond current market expectations to effect the tightening of financial conditions that is required. All of this increases the chances that the economy’s landing is a very bumpy one, if not outright recessionary. The Fed thinks it can avoid this but that is its view most of the time and, most of the time, it is wrong.