Markets will not truly consider the Fed serious about inflation until policy stresses markets by pulling up real yields to some critical level. The Fed turns serious once they recognize that deteriorating global conditions are not going to deliver the soft landing their policies need to be effective. From a timing perspective this means summer, at the earliest. Further, returning reserves to banks at the same time reserves left on deposit are losing real value and loan/asset ratios are depressed, is a prescription for banks to rebuild loan books. A look at loan growth over the past year, on into today, indicates banks are doing just that-- outstandings have surpassed the spring 2020 surge. This can morph current inflation from being shortage-caused to credit-induced and leave the Fed even further behind. From a growth standpoint, the Fed either gets a soft landing delivered to it now, or its ensuing chase eventually creates a hard landing – as it always does. The key word is “eventually”. Until the Fed starts walking its talk, the equity markets take emerging pro-cyclical inflation and rallies with it, aided by expanding bank credit.
How high for real yields is high enough? If a near-term soft landing is hard enough in impact, probably not very high, but the critical point is that the Fed needs to be pulling real yields up, not growth. Real yields have been falling for decades and the breakpoint for the economy has been dropping too. In the 1980s, the Fed drove real yields close to 6% before the economy moved into recession. By 2000, just over 4% did the trick and in 2007, 2.7% was enough.
The economy started to bend in 2018 after the real 10Y yield moved over 1% -- more to the point, the Fed was pulling real yields higher (unbeknownst to them, for some reason, by accelerating balance sheet run-off when the deficit jumped from the tax cuts, see Table 1). To date, real yields have risen from -104bp in March 2021, to about 0 as of yesterday. The shift in Fed policy has had some impact, but less so than in 2018, considering that the deficit is shrinking, and real policy yields remain deeply negative. Rising private credit demands have been a factor in the current real yield rise, and so too is current coupon mortgage duration extending from 5 years to 5.8 since the year began (it was 4, one year ago) –the amount shorting10Y UST has consequently increased. Against a backdrop of sharply slowing growth in the near-term, 50bp is probably high enough. If, however, a credit cycle manages to take hold, chances are the Fed will need to exceed 1% to slow things down.