TIPS yields are headed even higher: this is the takeaway from last week’s strong economic data. The labour market is getting tighter. Real incomes are rising. US growth is accelerating: real GDP rose by an annualised 2.41% q/q in Q2.
Real rates are still not restrictive enough. Inflation-indexed yields are stuck below 2% between 5- and 30-years. But hiking the federal funds rate may not be the most expeditious way for the Fed to achieve higher real interest rates across the curve.
Introducing forward guidance would constitute a more effective form of tightening. This would involve communicating that higher interest rates are here to stay. The pace of QT could be sped up, to achieve a positively upward-sloping yield curve.
To do this, FOMC participants should enter into a more serious discussion about why real interest rates may have risen post-pandemic and adjust accordingly their estimates of the long-run neutral rate of interest. According to the latest SEP, the inflation-adjusted neutral rate of interest remains just +0.5% (federal funds rate of 2.5% less the 2% inflation target).
WTI crude prices are now flat YTD (+0.01%), after climbing 13.5% in July. The Fed will not want to get behind the curve on shelter inflation for a second time. The FHFA house price index rose for a fifth straight month in May (+0.71% m/m and by an annualised 7.3% YTD) to a record high.
