Former Dallas Fed President "Bond Market Got Ahead of Itself"...Hints at Rate Freeze

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The possibility of the Federal Reserve (Fed) freezing the benchmark interest rate in October has increased. A warning has been raised that the market is overly overestimating the Fed's tightening intensity and adding excessive risk premiums to bond yields.

Former Dallas Fed President Robert Kaplan, in an interview with CNBC on October 1 (local time), lent support to the possibility of skipping an interest rate hike in October. Kaplan stated, "If I were in my former position, the bar for an October adjustment would have been very high." This is because economic growth has been boosted by the adoption of artificial intelligence (AI) infrastructure and defense spending, while interest-rate-sensitive sectors and consumption by middle-to-lower income households have stagnated. Core inflation is stabilizing, while headline figures remain high due to oil prices. Kaplan emphasized that for a cautious decision, they should skip October and observe the situation in December.

The bond market surged by more than 1 percentage point (100bp) ahead of the Fed's official decision. Market confusion regarding the remarks of Fed officials is cited as a major reason. The median dot plot of the Federal Open Market Committee indicated two rate hikes, including December. However, immediately after the press conference, the market priced in tightening of approximately 100bp. Kaplan pointed out that the market failed to properly grasp Kevin Warsh's signals, leading to an excessive accumulation of risk premiums.

The rising trend in oil and diesel prices due to geopolitical risks is also fueling inflation concerns. Approximately 50% of Russia's refining facilities are either shut down or operating at reduced capacity due to damage. The surge in diesel prices, used across logistics and food transportation, is spreading to price increases for dozens of items. The Fed implemented a 0.25 percentage point hike in September and has not abandoned its tightening stance.

Kaplan predicted that the Fed's actual tightening moves would be more limited than market expectations. The observation is that it will amount to a total of three hikes (0.75 percentage points), including two hikes this year followed by one additional hike in early 2027. With the September hike, the benchmark interest rate has already entered the 4.25% to 4.5% range. For bond yields to stabilize downwards, oil price stability and the normalization of excessive market risk premiums are essential.

The combination of an October rate freeze and a December hike has emerged as a likely path for monetary policy. Amid commodity shocks and surging bond yields, market attention is focused on whether the Fed can quell excessive tightening fears and achieve a soft landing.

[Article Key Summary]

-Former Dallas Fed President Robert Kaplan suggested an October rate freeze followed by a December hike, citing weak consumption.

-The 100bp surge in the bond market is attributed to misinterpretation of Fed signals and diesel price instability due to refinery damage.

-The Fed's additional hikes are expected to be limited to a total of two, including December, indicating a need for the market's excessive premium to be resolved.

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