Could rates really hit 6%?

A few weeks ago, anyone who suggested the Federal Reserve might take the federal funds rate toward 6.0 per cent would have been written off as a scaremonger. By the end of February, swap markets had abandoned their hopes of an early easing, pushing the priced peak rate above 5.4 per cent, and traders were actively buying options against a 6 per cent policy rate. With monthly inflation picking up again and the labour market showing no strain, bond desks have to consider an awkward idea. A peak of 5 per cent may not be enough to hold prices down in an economy that has changed shape.

Markets overtake the Fed

The repricing has left the central bank's own guidance behind. In December the median official projected a peak of 5.1 per cent, and the long-run rate in those projections stood at 2.5 per cent. Since then January brought payroll growth of 517,000, core PCE inflation of 4.7 per cent and upward revisions to the late-2022 price data. Measured against that core inflation rate, the real funds rate at 4.5 to 4.75 per cent is barely above zero.

The case for stopping at 5 per cent rested on the belief that the neutral rate of interest (r-star) was still near its post-crisis level of 0.5 per cent in real terms. With a 2 per cent inflation target, a 5 per cent nominal rate was thought to deliver 250 basis points of real restraint.

Market pricing needs careful reading. A peak rate above 5.4 per cent in swaps is an average across possible outcomes, and the options trade tells a separate story: investors are paying to insure against a tail they had ignored. Both moves say the same thing about direction. The distribution of plausible outcomes for the funds rate has shifted upward, and the soft end of it, with cuts this summer, has almost disappeared.

Neutral may have moved

That reasoning is weakening. Bigger budget deficits and a shortage of workers are pushing the other way, and so are companies bringing supply chains home and heavy defence spending. If those changes have lifted the neutral rate toward 1.5 or 2.0 per cent, a 5 per cent policy rate barely restrains anyone.

The arithmetic is simple. A real neutral rate of 1.5 per cent plus the 2 per cent target puts the nominal neutral rate at 3.5 per cent, and one of 2.0 per cent puts it at 4 per cent, so a 5 per cent policy rate delivers only 100 to 150 basis points of restraint rather than 250. The economy's refusal to slow after 450 basis points of cumulative rate rises suggests that policy has been much less tight than the models assumed.

Lessons from 1994

The funds rate has not been as high as 6 per cent since early 2001. The closest precedent for a march to that level is 1994 and early 1995, when the Fed doubled the rate from 3 to 6 per cent. That cycle wrecked bond portfolios, pushed Orange County in California into bankruptcy in December 1994 and helped tip Mexico into its peso crisis the same month. The economy itself came through, which is why 1994 is remembered as a soft landing. The financial casualties came first, and they came in places where leverage and duration had been piled up on the assumption that rates would stay low.

Pressure beyond America

A 6 per cent funds rate would also be exported. Higher American yields pull capital toward the dollar, and a stronger dollar raises the cost of dollar debt for emerging-market borrowers and makes imported commodities dearer for everyone else. The Bank of Japan, which in December widened the band around its ten-year yield target to half a percentage point either side of zero, would face renewed pressure on that ceiling as the gap with American yields grows. Last year's surge in the dollar showed how quickly that pressure spreads from one market to the next.

Where things start to break

Going to 6 per cent would take the financial system into dangerous territory, where the damage grows faster than the rate. At that level, pressure to pay depositors more would become acute, and regional lenders would probably have to ration credit hard.

The weak point is the asset side of bank balance sheets. Lenders put the deposit flood of 2020 and 2021 into long-dated Treasuries and mortgage bonds, and those securities lose value with every rise in yields. Money market funds, which pass on higher rates far faster than banks do, are already drawing deposits away, and each further increase widens the gap a saver can capture by moving.

The cost of servicing federal debt would also balloon, putting interest spending on a path that cannot last. The Congressional Budget Office's latest projections, published this month, already show net interest outlays climbing steeply over the coming decade without assuming a 6 per cent funds rate.

Other borrowers would feel it too. Commercial property is the most exposed large sector: office buildings face falling occupancy as remote work persists, and owners with loans falling due must refinance at rates two or three times what they paid. Companies with floating-rate debt, many of them owned by private equity firms, would see interest bills rise again just as earnings slow. The winners would be savers in money market funds and Treasury bills, who would earn their best returns since the late 1990s.

Why the Fed may stop short

The strongest argument against a 6 per cent peak is that monetary policy acts with long lags. Thirty-year mortgage rates passed 7 per cent last autumn for the first time in two decades and housing activity has slumped, so part of the restraint already delivered has yet to reach the rest of the economy. If spring data show that, the Fed can pause near current market pricing. Jerome Powell's semi-annual testimony to Congress next week, the February jobs and inflation reports and the committee's new projections on March 22nd are the tests. A 6 per cent policy rate is probably the point at which higher rates stop merely slowing demand and start breaking things, beginning with the regional banks. If the Fed goes there this year, it should expect casualties.