Why Markets May Be Pricing in Too Many Fed Rate Hikes

Alison Nathan (0:05)

The Fed has just raised interest rates for the first time in three years. So was one increase enough to bring inflation down? Or should investors expect more rate hikes ahead? I'm Alison Nathan and this is Goldman Sachs Exchanges.

Today, we're unpacking what this shift means for companies, for interest rates, and for confidence in the Fed. With Goldman Sachs Vice Chairman and former Dallas Fed President Robert Kaplan. Rob, welcome back to Exchanges.

Robert Kaplan (0:33)

Good to be here.

Alison Nathan (0:34)

A treat to have you actually in the studio this time around. So as I just said, we have seen the first hike from the Fed in a number of years under new Chairman Kevin Warsh.

What was your first reaction to that? Did you think that was the right move?

Robert Kaplan (0:49)

I did think it was the right move. Remember, the Fed did three cuts in the fall of 25 I would not have done the third cut. They were worried about the labor market. We then get into 26 We've got tax incentives. We've got an AI infrastructure boom. And then you've got the war with an oil spike.

I think the Fed tried to be patient, tried to see if oil prices were going to settle back down. They haven't. And so I think they were right to do nothing in July, but I did believe that September was the time to act, and they did the right thing to raise rates in September.

Alison Nathan (1:24)

But let me ask you a follow up, because did they do the right thing because of inflation concerns, or because the market was so convinced it was going to hike that it didn't really have a choice? And is there a difference between those two?

Robert Kaplan (1:37)

Yeah, they had a choice. When you're sitting inside the Fed, I always think I have a choice. And if I think the market is way off, I can go out and communicate and give feedback to the market. But the problem was, month over month, year over year inflation, we know is problematic.

I.e. it's in the mid threes, but we understand. Part of that is oil prices a year ago were in the 60s. They're now close to $100, so that's not a shock. The thing that was problematic is the month over month numbers. I think they were hoping that those would cool and start to approach, say, 0.2 a month. So annualized 2.5%, let's say.

And unfortunately, they ran hotter than that. So even month over month, we're still running closer to 3

And I think once they saw that, I believe that it was the right thing to do to start taking action. Now, the issue is how many times do they need to move? And I think the dot plot, interestingly, was pretty muted, showed a pretty muted response, meaning they're going to raise in September. I think the median was one more increase. And then some thought they needed to do a little bit more than that. But I think the median showed they don't take any action in 2027 I would call that a fairly muted response. And the reason it's muted is the AI infrastructure part of the economy and AI adoption part of the economy is booming. There's no question about that. Defense spending, for obvious reasons, is very strong.

However, when you look at autos, housing related companies that sell the low moderate income consumers, business isn't terrible, but it's pretty sluggish or weak. So the interest sensitive parts of the market that are affected by the Fed funds rate are already, in my opinion, not overheated. And so these cross currents created a more muted response from the Fed.

Alison Nathan (3:42)

Right. So if you think about the fact that nine of the 10 officials are expecting at least one more hike, is that realistic? Are you saying they need to actually hike more? Because the market thinks they're going to hike more.

Robert Kaplan (3:54)

The market is anticipating that they're going to hike more. And if I were on the committee, my mindset would be, let's move in September. I would probably be inclined, unless there's a reason to act in October, I'd be inclined to skip October. We'll see if they do.

And then look again about moving again in December.

Then I want to take a fresh look and see whether or not we need to do more. The reason two moves resonates with me, that gets you to four, four and a quarter. There are three and three quarters to four right now.

I know Kevin Warsh said he doesn't use the neutral rate, doesn't look at it. And I agree with him, it's not the be all end all, but it's also, in my opinion, not irrelevant. I think the neutral rate for me is probably plus or minus one, one and a quarter real plus the inflation rate. I think the nominal neutral rate is around four, four and a quarter. So then the question once, if they raise it again in December, we're then at four, four and a quarter. I'm probably in the neighborhood of neutral. Maybe I need to do one more to be slightly restrictive, but I don't know that I need to do a lot more than that. And the reason again, I don't know is interest sensitive parts of the economy are not overheating. And so I'm sensitive to the fact that the one tool I have, the Fed funds rate, is potent, but it's not going to slow down the AI infrastructure build. It's not going to slow down defense spending. And I'm also aware that we've got this oil shock that maybe gets resolved. I don't know that it will, but if it got resolved, that would also cause me to rethink. And I'm aware of that and mindful of it.