The Fed Makes A Type 1 Error As Markets Move Toward Low Terminal Rate

The Fed Makes A Type 1 Error As Markets Move Toward Low Terminal Rate

The Federal Reserve raised rates again this month, this time on the same day the inflation reading came up as a disappointment. As a result, experts began talking about whether the U.S. central bank was making a policy error and also the irony of the rising funds rate and the market moving toward a low terminal rate.

Financial conditions ease up

Deutsche Bank analyst Dominic Konstam and team said in a recent report that financial conditions have eased up this month compared to where they stood in May. Interestingly, conditions eased even though the real Funds rate is now at the highest level it has been at since March 2008. They noted the irony in the situation, with “the rates market discounting not much more Fed and a low terminal rate.”

They added that there’s a fine line with risk now, as risk can do well if inflation remains low while growth is robust, which is known as a “falling price boom.” They explained that this setup allows for a low terminal rate that’s based more on low inflation. Additionally, they said that this presumes that the Fed can’t force the issue much further past making up for the negative term premium.

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Markets worry about type 1 error or type 2 error on the way to a low terminal rate

The DB team examined the “flattening and compression of spreads to the Funds rate” against the backdrop of the market moving toward a low terminal rate. Because the Fed raised rates the same day inflation disappointed again, they said it’s natural for the markets to worry that the central bank made a policy error.

They feel that the Fed made a Type 1 error, a major shift from when Janet Yellen was Fed chair and favored optimal control, which was focused entirely on avoiding a Type 2 error. The DB team defined a Type 1 error as “acting for fear that there is rising inflation risk” and a Type 2 error as “not acting when there is rising deflation risk.” The analysts warned that the Fed now runs the risk of making a Type 2 error now that it has made a Type 1 error.

“It all depends on the behavior of risk assets and the robustness of real growth through what is at the very least a soft patch for inflation,” the DB team wrote.

Inflation is the top concern

They add that one way to appreciate the risk of the Fed making a Type 2 error is through the 5y5y-Funds spread, which stood around 150 basis points, the tightest level since January 2008 when the Fed was scrambling to reduce rates. They also note that the 2s funds also finally fell below 25 basis points.

The Deutsche Bank team feels that 5y5y is a good proxy for the terminal rate, adding that it has cut through the Funds rate’s past high levels. Looking at a three-year forward basis, 5y5y was at 2.75%, leaving plenty of room for the 5y5y rate to fall if the Fed is at risk of making a Type 2 error. They give the example of the terminal rate at 1.5% to 2%, which would mean that everything would be roughly flat at 2. So if the Fed commits an error, rates will go even lower.

 type 2 error Type 1 error low terminal rate

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