Markets Are In for an Interest-Rate Surprise

A 4.5% peak in the Fed’s target rate isn’t out of the question.

10 May 2021, 6:00 pm GMT+8

He might surprise you. Photographer: Daniel Acker/Bloomberg

When Treasury Secretary Janet Yellen recently made the innocuous observation that the Federal Reserve might at some point have to increase interest rates to keep inflation in check, financial markets became so flustered that she had to revise her comments.

She was right the first time. I would go even further: Not only will the Fed have to raise rates, but rates are likely to go much higher than investors anticipate. 

Markets expect short-term interest rates to remain very low for a very long time. Prices in the Eurodollar futures market, which has active contracts extending out into 2027, suggest that U.S. short-term rates will peak no higher than 2%. I see two reasons to believe this forecast is improbably low.

First, consider the “neutral” level for the Fed’s short-term interest-rate target — that is, the rate at which the central bank would be neither supporting nor braking economic growth. Judging from Fed officials’ latest economic projections, they think the rate consistent with 2% long-run inflation would be somewhere between 2% and 3%, with a median of 2.5%. This seems reasonable: It suggests an inflation-adjusted neutral rate of 0.5%, which is well below the long-term historical average of about 2%. And if history is any guide, the Fed will have to take rates considerably higher than neutral before its tightening cycle is done.

Second, the Fed’s new long-term policy framework implies even higher peak rates. The central bank has made it abundantly clear that it won’t start raising rates until inflation is expected to exceed its 2% target for some time — which, in my view, means it will probably have pushed the economy past maximum employment, and then will need to make monetary policy tight to cool the economy down. How far it must go will depend on what happens with inflation, which is difficult to predict with any precision. That said, it’s not hard to imagine the Fed taking its short-term target rate to 3% or even higher.