Fed’s Daly says financial markets act as if interest rates are much higher than they actually are

Financial market conditions appear much tighter than the actual level of the Federal Reserve’s benchmark interest rate suggests, San Francisco Fed President Mary Daly said.

Citing new research from his regional bank, Daly said on Monday that the tightening in markets was more akin to a benchmark rate of around 6%. That’s well above the actual level of 3.75% to 4% which Daly said should only “modestly” slow the economy.

Markets seem to be feeling the impact of the Fed’s balance sheet reduction or quantitative tightening. Additionally, the market is paying attention to forward guidance from the central bank on the need for higher rates, Daly said. She spoke with the Orange County Business Council and then answered questions from reporters.

The Fed said earlier this month that it would continue raising rates until the level slowed the economy “enough” to reduce the high rate of inflation.

Fed officials are debating what that level might be. Daly said his latest estimate would put the Fed’s benchmark rate around 5%.

The rate could rise if incoming inflation data remained hot, she added.

St. Louis Fed President James Bullard said the rate could be between 5% and 7%.

Opinion: What did Bullard get wrong about a 7% federal funds rate?

Daly said ignoring the true impact of Fed rate policy on the economy would increase the risks of over-tightening, leading to a recession.

“As we make decisions on further rate adjustments, it will be important to remain mindful of this gap between the fed funds rate and the tightening in financial markets. Ignoring it increases the chances of overtightening,” Daly said.

The Fed could also tighten its positions if it ignores the “lags” of all rate hikes so far this year.

The Fed raised its key rate to a range of 3.75% to 4%. Rates were close to zero in March.

“We have to take into account that while financial markets react quickly to policy changes, the real economy takes longer to adapt. Neglecting this lag can make us think we need to go further when in reality we just have to wait for past actions to work their way through the economy,” Daly said.

Investors cheered when US inflation slipped to 7.7% in October from 8.2% the previous month. But Daly said it was ‘far too early to call it a turning point’.

Daly said she viewed “basic services and basic goods” as indicators of future inflation. Base rates eliminate food and energy prices.

Overall, Daly said she sits on the “hawk” end of the opinion spectrum among senior Fed officials.

“I really want to make sure the job is done right and completely. Inflation is a regressive tax. It hurts most those least able to bear it. To finish early in the hope that it will pass and that we have done enough does not satisfy me at all,” she said.

In a separate interview on CNBC, Cleveland Fed President Loretta Mester said the Fed has raised rates enough that it can now slow after four consecutive 0.75 percentage point hikes.

“I think we can slow down from 75 at the next meeting,” Mester said. But she added that the central bank was not considering pausing or halting rate hikes.

“I don’t think we’re anywhere near stopping,” she said.

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