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Markets Brace For Impact As Fed Likely To Push Rates Higher

Derek Wolfe

Updated: January 12, 2023

Fed rates higher
Editor’s Note:

EDITOR'S NOTE: Markets may be exuding optimism now, but as economic reports roll in, the Fed will likely push interest rates far beyond what the markets consider favorable. This is the opinion of economist Ricardo Reis of the London School of Economics. He warns that markets are going to get rocked as the Fed splashes cold water on investors’ unreasonably sunny expectations. The current Fed Funds rate stands at 4.33%. Wall Street knows that the figure is going much higher. So, what’s with the optimism that’s seemingly infecting the investing public? Perhaps investors can’t fathom the potentially damaging effects of each gradual basis point hike. So, how high might the Fed push its “terminal rate,” and how might that transform the economy? Read on to get one economist’s take on the matter. 

Benchmark rate of 5.5% is minimum — the market now eyes a terminal rate of 5%.

The Federal Reserve is likely to raise interest rates more than the markets now expect, says Ricardo Reis, an economist at the London School of Economics.

“Markets are going to get rocked,” Reis told MarketWatch on the sidelines of the American Economic Association annual meeting in New Orleans on Saturday.

“All the risks are on the upside. A rate of 5.5% is the minimum,” he added.

Last month the Fed raised the top end of its benchmark rate range to 4.5%. The central bank penciled in a 5.25% terminal rate.

Investors who trade in the fed-funds futures market now expect the Fed to stop raising when rates get to 5%.

Reis thinks the central bank will ultimately move rates higher.

The Fed is burned by failing to recognize the persistent upward move of inflation in 2021, he said.

“So I think they are biased toward over-tightening,” he said. “Either legitimately or because they are worried about fixing their past mistake, there are going to be tighter than you think.”

The economy is at a turning point and the Fed does face some “tough calls,” Reis said.

The key going forward is the path of wages.

Workers need to have their wages go up because their paychecks have not kept up with inflation.

So the Fed is going to have to gauge if the rise in wages is too much, just right or too little, he said.

If wages don’t rise much, inflation can quickly return to the Fed’s 2% target, he said.

If wages rise in line with productivity, the Fed won’t have to raise too much and inflation will come down to 2% in a few years.

This will be difficult because productivity is an economic variable that is hard to measure.

If wages spike, this would probably cause companies to continue raising prices, kicking off a wage-price spiral, Reis warned.

The Fed might overreact to the rise in wages, he said.

There is a scenario where rates go up “much more,” Reis said. But there is a range — it could be “much much more” or “much more” or “just more.”

Reis said that he was sympathetic to the idea that raising the unemployment rate to 5.5% was not a terrible outcome if it means a return to low inflation.

The unemployment rate hit 3.5% in December.

Stocks DJIA, 0.35%   SPX, 0.66% moved sharply higher Friday when the government reported relatively slow increase in wages in December. The yield on the 10-year Treasury note TMUBMUSD10Y, 3.572% fell to 3.56%.

 

Originally published by Greg Robb at MarketWatch

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