The Federal Open Market Committee, the group of central bankers that sets U.S. monetary policy, will meet next week. The members will have to consider the possibility that in trying to clarify their "exit strategy" from quantitative easing and zero interest rates, they've tightened policy more than they intend.
Monetary conditions are certainly tightening. The accompanying graph depicts the market's expectation of the federal funds rate, the baseline short-term interest rate the Fed targets, from now to 2016. It shows that expected rates have risen sharply over the last month. (Expected rates hadn't moved much before that this year.)
The market had thought last month that, in April 2016, the Fed would have the rate at 0.75 percent. It now thinks it will be 1.15 percent at that time. Since the target rate is set in increments of 0.25, that implies a 60 percent chance of 1.25 percent and a 40 percent chance of 1 percent. Similar hikes have occurred across the board.
That's a serious tightening in a very short time: Expected rates have risen on average 40 percent. The timeline of rate hikes has leapt forward 8 months. Economists generally think that monetary policy's most powerful channel is through expectations, so the Fed's shift could have a big impact.
The shift is all the more remarkable because there hasn't been an explicit change in strategy. Fed officials have insisted that their explanations of "tapering" don't signify a new policy. Apparently, the market doesn't believe them.
Maybe the markets expect much more rapid Fed hikes because the economic outlook has brightened so much over the past month. This explanation doesn't hold much water: Stock markets and other leading indicators are flat. Nor have economic forecasters changed their views.
"It's possible it could be some of each," said Scott Sumner, a Bentley University economist. "It would seem to me that you might have a little bit of money tightening and a little bit of stronger economy. But I lean towards the view that the market is thinking the Fed will be tighter than they had thought."
But why? The likeliest suspects are the Fed committee's most recent minutes, which were released on May 22 and the testimony of Chairman Ben Bernanke before the Congress on the same date. Markets read the events as evidence for a quicker tightening.
Interest rates on longer-term lending reflect the sum of shorter-term rates. Fed futures data, therefore, may indicate that anticipated tightening, rather than economic gains, are driving the abrupt rise in Treasury and mortgage bond yields.
If the Fed can't clarify without tightening, that's a big problem for monetary policy. The next few stages of the exit are necessarily complex. If it wants to avoid snuffing out the recovery, the Fed will need to clarify its clarifications. Next week won't be a moment too soon.
(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)