Home Economy The bond market is sitting next to a sleeping tiger — the Federal Reserve

The bond market is sitting next to a sleeping tiger — the Federal Reserve

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         The bond market is sitting next to a sleeping tiger — the Federal Reserve

The bond market seems unaware it is sitting next to a sleeping tiger — in the form of the Federal Reserve, said Jan Hatzius, chief economist at Goldman Sachs.

The U.S. central bank is going to have to be much more aggressive than the bond market has discounted, or Fed officials now believe, in order to slow the economy to a sustainable pace, the prominent economist said in a note to clients released late Monday.

At issue is a technical but important debate currently underway about why the U.S. economy is so sluggish with interest rates so low.

Fed officials have come to believe the economic evidence points to a decline in a key interest rate for capital caused by a lack of demand for funding new projects and a glut of global savings. The Fed calls this rate r*, the short-term interest rates, adjusted for inflation, consistent with full employment at 2% inflation.

This theory has a lot of important consequences, including that the Fed will only have to inch interest rates up over the next few years in order to keep the economy on an even keel.

Hatzius takes a different view. In his note, the Goldman Sachs economist argued the current low-rate environment tells a completely different story: that economic growth might have become “less sensitive” to low interest rates.

The Fed has penciled in three rate hikes per year, the slowest tightening cycle in the post-World-War-II era.The bond market discounts even this tightening pace.

Goldman expects a faster pace of tightening: hikes in June and September followed by balance-sheet runoff announced in December, followed by a rate hike each quarter until the funds rate hits 3..25%-3.5% at the end of 2019.

The Goldman chief economist has been warning all year about the possibility of a faster pace of rate hikes.

Read: Goldman’s Hatzius: Investors could get blindsided by a cluster of Fed hikes this year.

Hatzius admitted that the facts on the ground support both his argument and the Fed’s view.

“Our analysis suggests, at a minimum, that reality might be somewhere in between, consistent with our view that Fed officials will ultimately raise the funds rate by significantly more than discounted in the bond market,” he said.

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