Morning Must-Read: Tim Duy: On The Fed Credibility Gap

The markets think Fed officials and staff economists are overly optimistic about the U.S. economy, as they have been in the past….

I will suggest another framework: Financial markets are pricing in a ‘secular stagnation’ scenario that is at odds with Federal Reserve thinking…. Suppose that the short term equilibrium real rate has fallen to zero…. Change the estimate of NAIRU from 5.6% to 5%… close to pre-recession Fed estimates. The results… [are] fairly close to market expectations…. It thus appears reasonable to argue that financial market participants are pricing in a secular stagnation story combined with a pre-recession level of NAIRU. In contrast, the Fed is not seriously contemplating such a story…. The biggest risk to the expansion is a dogmatic view… on the part of the Federal Reserve…. Financial market participants are saying the Fed has less room to maneuver than monetary policymakers believe. The Fed, I fear, is not taking sufficient heed of those signals. Would it be outrageous to think that the Federal Reserve could find itself backtracking after just 200bp of rate hikes? Not if Sweden serves as any example…. The Fed… risk[s] tightening too aggressively and turning an expansion that should last at least four more years into one with only two left.