The Federal Reserve will need to raise its key interest rate to 5% to cope with high inflation, according to Deutsche Bank.
This defies any hope of policy change in the near future. Shortly after August inflation came in above estimates of 8.3%, markets appreciated expectations of another 75 basis point rate hike from the U.S. Federal Reserve next week, sending stocks to their biggest one-day drop since 2020.
“Despite the recent jump in market prices, the Fed funds rate, [our] the analysis therefore points to a further upside risk to terminal rate expectations,” a team of German economists warned in a note on Thursday, adding that continued “surprises” in inflation news could lead to a terminal rate above 5%.
That’s largely because inflation still remains “well above” the Fed’s 2% target, and while other experts pointed to prices falling across the board, the jobs report showed the labor market was still buoyant, which Fed officials interpreted as a sign that the economy can withstand further tightening.
Powell earlier said the Fed would continue to tighten “until the job is done” and hinted the Fed would pursue a neutral rate — a level of rates no longer restrictive to the economy — before thinking about tapering.
However, the neutral monetary policy rate is often achieved by overshooting the inflation rate, the bank said. Deutsche’s analysis of previous inflationary cycles showed that the final exchange rate almost always exceeded the rate of inflation to “ensure sufficient tightening” of the economy, regardless of whether inflation was severe or mild.
Economists have estimated that the Fed will need a 0.25% real neutral rate, or overshoot, to fully catch up with inflation, which is likely to disappoint rate-cut investors.
“In particular, with core PCE inflation now likely to remain north of 4.5% through the end of the year and into early 2023, the terminal funds rate will need to exceed these levels… Allowing for a slightly positive real neutral rate, a terminal rate above 4.5 % will probably be necessary,” the bank said.
However, inflation continues to dampen estimates and the labor market remains tight. That could push the terminal rate above 5%, more than double the Fed’s 2.25%-2.5% range.
“We see risks skewed hawkish at the moment,” the bank warned. Other analysts have speculated that the United States could slide into recession from the long-term hawkish Fed, and billionaire investor Ray Dalio predicted this week that a rate hike to 4.5% could lead to a 20% drop in the stock market.