Why slowing down could mean the Fed goes higher

Interest-rate futures are pricing a fourth consecutive 75-basis-point rise at the Federal Open Market Committee's November meeting, which would take the policy rate to 3.75 to 4.00 per cent. Traders are also arguing about when and how the Fed will slow down. The emerging consensus is that it will step down to a 50-basis-point rise in December, and risk assets have rallied on the idea. The rally misreads the arithmetic. Smaller rate rises do not signal an early pause. They are how the Fed can take rates higher and keep them there for longer.

The reasoning is about managing risk. Moving in steps of 75 basis points puts strain on the financial plumbing and could break fragile credit structures before the economic effects of earlier rises can be judged. Smaller steps give policymakers the room to keep raising rates well into 2023 and push the peak towards 5 per cent without causing a sudden liquidity accident.

How the pace got so fast

The committee has come a long way in seven months. It lifted its target range off zero with a quarter-point rise in March, added half a point in May and has delivered 75 basis points at each meeting since June. In September the median official projected a policy rate of 4.4 per cent by the end of this year and 4.6 per cent by the end of next, and the futures market has since moved above both.

The data gave little reason to relent. Consumer prices rose 8.2 per cent in the year to September, and core inflation, which strips out food and energy, reached 6.6 per cent, its highest in four decades. A central bank facing those numbers does not stop because markets would like it to. It changes the size of its steps.

Slower, but further

Fed officials know that monetary policy works with long and variable lags. A committee moving at breakneck speed risks overshooting, because the data it sees today reflect conditions set twelve to eighteen months earlier. Moving in steps of 50 or 25 basis points lets the committee feel its way towards the right peak rate with more care.

Other central banks have already made the switch. The Reserve Bank of Australia slowed to a quarter-point rise in early October, and the Bank of Canada raised rates by half a point on 26 October when markets had expected more. Neither said it had finished. Both framed the smaller step as a way to keep going while watching the effects of what they had already done.

Bond markets, though, tend to confuse a slower pace with a smaller ambition. When traders see a smaller rise, they bring forward their expectations of a pause and start pricing rate cuts for the following year. The resulting easing in financial conditions, seen in higher share prices and lower mortgage rates, works against the Fed's fight with inflation. To counter it, the Fed has to pair a slower pace with a higher projected peak rate.

The 2004 template

The Fed has run a slow, long campaign before. From June 2004 it raised rates by a quarter point at seventeen consecutive meetings, taking the policy rate from 1 per cent to 5.25 per cent by June 2006, and then held it there for more than a year. No single step was dramatic. The cumulative effect, and the length of the hold, did much to cool the housing market that later broke.

That episode is the better guide to what a step-down means. The market tends to fixate on the size of each move, while borrowers are hurt by the level and by how long it lasts. A policy rate that reaches 5 per cent in small increments and sits there does more work than one that reaches 4 per cent in a hurry and is cut soon after.

Paying for longer

For corporate borrowers, a high rate held for a long time does far more damage than a sharp spike that quickly reverses. Companies entered 2022 with plenty of cash and long-dated debt, which protected most investment-grade balance sheets from the first round of rate rises. Had the policy rate peaked at 4 per cent and come down quickly, the damage to corporate cash flow would have been modest.

If the federal funds rate settles near 5 per cent and stays there through 2023, refinancing will start to hurt in earnest. Term loans and revolving credit lines tied to SOFR will charge interest at rates not seen in fifteen years, eating into free cash flow quarter after quarter. Inventory will cost far more to carry, and boards will drop marginal projects that depended on borrowed money.

The pain is spread unevenly. Leveraged-loan borrowers, whose debt floats, feel each rise within a quarter; investment-grade companies with fixed-rate bonds feel it only as their debt matures. Households are somewhere in between: the average 30-year mortgage rate has climbed above 7 per cent for the first time since 2002, which has already frozen much of the market for existing homes.

Where the dovish case is right

The best argument for a shorter cycle is that the lags are already biting. Housing is contracting, the yield curve between two- and ten-year Treasuries has been inverted since the summer, and a strong dollar is squeezing American exporters. If inflation turns down sharply over the winter, a peak near 5 per cent could prove to be more than the economy needs.

That risk is real, but the committee's recent history argues against acting on it early. Officials underestimated inflation for most of last year and have said repeatedly that easing too soon is the error they most want to avoid. Chairman Powell's press conference on 2 November and the new projections in December will show whether the committee's own peak estimate moves up to meet the market.

The argument over the size of the next step is therefore a distraction. A Fed that slows its rate rises is pacing itself to climb higher, and companies refinancing through 2023 will feel a 5 per cent rate that stays put more than they felt the rapid climb. Investors celebrating the end of 75-basis-point rises will probably find that a long stay at 5 per cent is far more restrictive than the ascent that came before it, with floating-rate borrowers the first to feel it and the lowest-rated among them the first to default.