The end of the zero interest rate policy

When it comes to monetary policy, it is the goal that counts, not the path. What ultimately shapes the economy and markets is not the tactical moves of a central bank, but how much it ends up raising interest rates.

Driving the news: Now a seismic shift is underway in the outlook for the so-called terminal rate of this tightening cycle.

• Since a high inflation reading on Tuesday, expectations have risen that the Fed will end up rising much higher than seemed likely a week ago. It causes stock prices to fall and increases the likelihood of a recession.

Why it matters: If the prospects that markets are rapidly pricing in become a reality, it will mark the end of an era when interest rates seemed perpetually fixed near zero.

• Only maybe ZIRP (zero interest rate policy) doesn’t exist anymore. At least that’s what the bond market is now pricing in, with 1-year Treasuries now yielding more than 4%, the highest since 2007.

Using the numbers: For example, on September 9, futures markets were pricing in a less than 1% chance that the Fed’s interest rate will be above 4.5% by February. By Friday morning, those rates had risen to 36%, according to CME Group calculations.

• Mechanically, higher interest rates make every dollar of future earnings worth less today. That helps explain why the S&P 500 is down 7% since Monday’s close (10:00 a.m. EDT on Friday).

The mainstream view is that the Fed’s target interest rate will reach the 4% threshold by the end of this year. This rate is currently just under 2.5%. Some commentators now see a price target near 5% or something close as likely.

What you say: Economists at Deutsche Bank analyzed the potential endpoint for the Fed’s interest rate using a few different approaches, noting that they all “suggest that an interest rate of or around 4.5% may be needed by early next year.”

• But chief US economist Matthew Luzzetti and three colleagues argued in a research note published yesterday that “taking into account risk management considerations, a rate approaching 5% is likely to be required.”

This seemingly small difference has a massive impact on financial investments.

• Ray Dalio, the founder of massive hedge fund Bridgewater, argued in a LinkedIn post that if the Fed hikes rates to 4.5%, it implies a 20% drop in stock prices due to the higher discount rate on future earnings and lower incomes.

What’s next: After their September 21 policy meeting, Fed officials will release new forecasts, including their own expectations for interest rates.

• In June, median official interest rates would peak at 3.8% by the end of next year; On Wednesday we will learn whether they have revised these forecasts upwards.