Dominique Dwor-Frecaut is senior macro strategist at research firm Macro Hive, and formerly generated trade strategies for macro hedge funds, including at Bridgewater. In her more than two decades’ experience, she has developed in-depth analysis of central bank policies at the US Federal Reserve (Fed), IMF and World Bank.
Dominique Dwor-Frecaut has sparked debate with her view that the federal funds rate (FFR) could reach 8% this year, which would be its highest level since 1985.
Following a decade of loose monetary policy, exacerbated by quantitative easing during the pandemic, rising inflation during 2022 forced the Fed to start hiking interest rates. The FFR target stands at 4.50% to 4.75%, compared to 0.25% a year ago.
These hikes have put downward pressure on equities markets, with many observers hoping for a reversal in monetary policy. Dwor-Frecaut, however, believes that the FFR should—and, by the end of the year, feasibly could—be substantially above current levels.
Recent US economic data has bolstered her position. On 24 February, the Personal Consumption Expenditures Price Index rose 0.6%, indicating that core inflation is not slowing. “Consumer demand, employment, [and] non-residential investment are picking up,” Dwor-Frecaut told Opto, “which shows Fed tightening is not biting.”
Dwor-Frecaut’s stance is based on the Taylor Rule, which calculates a central bank’s optimum targeted short-term interest rate based on inflation and measures of economic slack, such as gaps in output and unemployment. Dwor-Frecaut describes it as “a rule of thumb linking the FFR to the deviation of inflation and unemployment from their [long-term] equilibrium.”
“Historically, Fed tightening cycles start when the gap between the Taylor Rule and actual FFR is wide and end when the gap is small,” says Dwor-Frecaut. “My estimate of the Taylor Rule FFR is around 8%, so the Fed has a way to go!”
“My estimate of the Taylor Rule FFR is around 8%, so the Fed has a way to go!”
Financial shocks and tight policy
While the Taylor Rule is not without its detractors, given the ongoing heat in the US economy, Dwor-Frecaut is “reasonably confident that a FFR somewhere around 8% is more a question of when than if.”
The timing depends largely on when the next financial shock hits the US. “For instance, a sharp increase in energy prices around mid-year would see the Fed pick up the pace of tightening and could see the end-2023 FFR above 7%.”
Barring a significant shock, however, Dwor-Frecaut expects the Fed to continue with small rate hikes throughout the year. “In that scenario, the FFR could end 2023 around 6%.”
Keeping it loose
Dwor-Frecaut is of the opinion that certain structural factors have made the US economy immune to Fed tightening.
These include the pandemic easing, which is “still working its way through the US economy”; the long-term, low-rate funding locked in by US households and businesses during decades of low rates; and “very strong household balance sheets due to the post-GFC deleveraging”.
This begs the question of why the Fed hasn’t already pursued a more hawkish policy. Dwor-Frecaut believes there are three reasons for this.
Firstly, three decades of low inflation have influenced its decision-making. The Fed “moved to average inflation targeting, meant to fight too-low inflation, in August 2020, just before inflation started to take off.”
Secondly, the Fed’s primary inflation model, which predicted transitory inflation, has proven to be flawed. While the Fed no longer maintains that inflation is transitory, it “has not adopted a new inflation model that would allow it to be forward-looking and consistent”, says Dwor-Frecaut.
“Instead, the Fed has decided to react to actual inflation prints which, in a period of rising inflation, implies that it will remain behind the curve.”
Thirdly, “the Fed wants to be popular”, which means “it is not prepared to inflict the painful medicine required by the US economy.”
Dwor-Frecaut’s analysis has exposed the necessity of that pain. The short-term impact of the Fed raising rates to near 8% would be a recession, “which is needed to bring inflation back to the target”.
In the medium term, “some systemic financial instability is likely because public and private debts are so high and we are coming out of decades of very low yields.”
Should the macro environment take a turn for the positive, however, Dwor-Frecaut does not view rates this high as an inevitability: “For instance, a collapse in oil prices below $40/barrel; a sharp increase in the household savings rate; [or] a complete turnaround in fiscal policy towards consolidation” could justify a return to (relatively) loose monetary policy.
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