The end of the zero rate policy

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With monetary policy, what matters most is the destination, not the journey. What ultimately shapes the economy and the markets is not the tactical maneuvers of a central bank, but How many he ends up raising interest rates.

Driving the news: Now, a seismic shift is underway in the outlook for the so-called terminal rate of this tightening cycle.

  • Since Tuesday’s high inflation reading, expectations have risen that the Fed will eventually climb much higher than it seemed likely a week ago. This drives down stock prices and increases the chances of a recession.

Why is this important: If the outlook quickly priced into the markets becomes a reality, it marks the end of an era when rates seemed to be perpetually stuck at zero.

  • Maybe the ZIRP (zero interest rate policy) is no more. That, at least, is now priced into the bond market, with one-year Treasuries now yielding over 4%, the highest since 2007.

By the numbers: On September 9, for example, futures markets estimated the probability that the Fed’s target rate would be above 4.5% by February at less than 1%. By Friday morning, those odds had risen to 36%, according to CME group calculations.

  • Mechanically, higher interest rates make every dollar of future income worth less today. This helps explain why the S&P 500 is down 7% since Monday’s close (as of 10 a.m. EDT Friday).

The dominant view is that the Fed’s target rate will hit the ballpark of 4% by the end of this year. This rate is currently slightly below 2.5%. Some commentators now see a rate target close to 5%, or something close, as likely.

What they say : Deutsche Bank economists analyzed the potential endpoint of the Fed’s target rate using a few different approaches and found that they “all suggest that a federal funds rate at or around 4.5% could be required early next year”.

  • But US Chief Economist Matthew Luzzetti and three colleagues argued in a research note published yesterday that, “given risk management considerations, a rate close to 5% is likely necessary.”

This seemingly small difference has massive implications for financial assets.

  • Ray Dalio, the founder of the massive Bridgewater hedge fund, argued in a LinkedIn post that if the Fed ends up pushing rates to 4.5%, it implies a 20% decline in stock prices due to the higher discount rate for future earnings, as well as lower incomes.

And after: Following its policy meeting which will end on September 21, Fed officials will issue new forecasts regarding, among other things, their own expectations for the course of interest rates.

  • In June, the median civil servant thought rates would reach 3.8% at the end of next year; on Wednesday we find out if they have revised those forecasts up.

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