Former Dallas Fed Chief Flags Market as Overestimating Rate Hike Path

Bond traders are pricing in too many Federal Reserve rate hikes, according to Robert Kaplan, the former president of the Federal Reserve Bank of Dallas. Speaking on a Goldman Sachs podcast recorded on Tuesday, Sept. 22, Kaplan said the Fed was right to raise rates in September and would probably be right to raise them again in December, but should hold in October.

The gap between his view and the market is wide. The Fed's own dot plot, the quarterly chart of policymakers' rate projections, shows one more hike this year. As of Thursday morning, Sept. 24, financial markets were pricing in at least three more hikes by the middle of June, MarketWatch reported.

Why Kaplan supports some tightening

Kaplan described inflation as "problematic" on both a monthly and a year-over-year basis, with even the monthly readings running closer to 3% on an annualized basis. That is the case for continuing to raise rates.

His case for stopping soon rests on where rates already stand. A quarter-point hike from the current level would put the federal-funds rate in a range of 4% to 4.25%. Kaplan said that is in the neighborhood of the neutral rate, the level that neither speeds up nor holds back the economy. "Maybe I need to do one more to be slightly restrictive, but I don't know that I need to do a lot more than that," he said.

A two-speed economy

Kaplan's argument is that the parts of the economy the Fed's rate most directly affects are not overheating.

"The AI infrastructure part of the economy and AI adoption part of the economy is booming; there's no question about that. Defense spending, for obvious reasons, is very strong," he said. "However, when you look at autos [or] housing-related companies that sell to low- [and] moderate-income consumers, business isn't terrible, but it's pretty sluggish or weak."

Auto sales and housing depend heavily on borrowing, which is why they respond to rate changes faster than most sectors. "So the interest-sensitive parts of the market that are affected by the fed-funds rates are already, in my opinion, not overheated," Kaplan said.

Why the market is pricing in more

Kaplan attributed the extra hikes in market pricing to a cushion that traders are building against three uncertainties:

• How new Fed Chairman Kevin Warsh will respond to economic data, which traders do not yet understand well.
• The Trump administration's inability to end the war in Iran.
• The risk that oil prices staying higher for longer will "bleed" into 30 or 40 other items.

Markets moved further in that direction after the podcast was recorded. The 2-year Treasury yield, which closely tracks expectations for Fed policy, rose another 12 basis points.

Long-term yields and the deficit

Kaplan tied the rise in long-term yields above 5% to the federal budget. Earlier in the year, he said, the expectation was that economic growth would slow the increase in the deficit. Since then, the Congressional Budget Office has revised its deficit estimates higher. "And it's probably causing the market to be a little bit more discouraged that we have got a grip," he said. He added that no fiscal-consolidation plan has been announced.

The distinction matters for investors. Short-term yields respond mainly to the Fed's rate path, while long-term yields also reflect how much debt the Treasury must sell. A change in Fed expectations would therefore not by itself settle the fiscal concerns Kaplan describes.

The October and December Fed meetings

• The Fed's October meeting, where Kaplan says a pause would be right, and its December meeting, where he says another hike probably would be.
• Monthly inflation data, and whether the annualized pace stays near 3%.
• Market pricing for hikes through June, compared with the single additional hike in the dot plot.
• Any further CBO revisions or a fiscal plan from Washington, which Kaplan links to long-term yields.