Why the Fed May Have to Hike Far Higher Than Expected | Henry Peabody on the Fed’s Triple Mandate and Uneven Transmission of Monetary Policy

Henry Peabody described credit transmission as an unofficial third mandate for the Fed: as lending has shifted toward capital markets and nonbank lenders, it has become harder to track how rate policy reaches the economy. The result is uneven pressure. Large, high-quality companies and other borrowers with market access can still raise money, while weaker businesses and consumers face more expensive or restricted credit. Peabody argued that this unevenness may force the Fed to keep rates higher for longer, or raise them further than markets expect, to restrain demand and inflation.

Market conditions show the divide. Tight credit spreads, high equity prices and subdued volatility point to easy financing for borrowers able to tap markets, while mortgages around 6% are slowing housing activity. High-quality used-car loans are above 7%, and Peabody said triple-C borrowers face clearing coupons well above 10%, probably above 12%. Consumers dependent on short-term financing are particularly exposed, with inflation further eroding affordability for the weakest wage cohort. Mortgage rates at 7%–8%, he warned, would put additional pressure on housing.

Peabody sees credit and the economy as K-shaped, with AI-related companies among those still able to borrow across investment-grade, high-yield, secured and project-finance markets. Investment-grade issuance is forecast to be about $200 billion higher next quarter than in the same period last year. He said some of this borrowing appears relatively insensitive to rates, while credit investors increasingly group companies under generic AI risk rather than assessing them individually. Meanwhile, floating-rate leveraged loans and private-credit debt expose borrowers to rising coupons and weaker interest coverage; some companies have leverage above six times.

Stress is more visible among weaker borrowers, including those unable to refinance low-coupon debt. Peabody expects defaults to be higher in a year, but is not predicting a spike; wider triple-C spreads indicate that defaults are rising. Recoveries also matter: software companies may have few hard assets, and AI-driven redundancy could leave very little to recover. He cautioned that nonbank lenders have not tightened as linearly as banks, while delayed loss recognition and less-visible asset marks make stress harder to measure. Still, he said the credit system is less levered than in 2008 and did not equate its opacity with a comparable systemic crisis.

The Fed’s challenge is that rate-sensitive borrowers are already under strain while asset prices and some balance-sheet growth appear less responsive. Peabody sees a risk that the central bank may need to use past-cycle playbooks to contain asset-price inflation. Improving ISM and regional survey readings, AI investment, employment and demand suggest stronger growth and a flatter yield curve, but he said it is uncertain whether that growth is sustainable or AI will transform productivity. He expects further curve flattening, and sees three-to-five-year Treasuries as a potential hedge when risk assets sell off, though high real rates make extending duration less compelling.

Peabody argued that the post-2020 shift to higher inflation and capital costs reflected fiscal-monetary cooperation during COVID, not simply a “transitory” forecasting mistake. Long-term rates, in his view, reflect higher real and forward rates as markets adjust to a higher equilibrium-rate regime and question how quickly inflation can fall; he does not see a material widening in breakeven inflation. If inflation remains above 3%, or around 3.5%, for years, investors should not assume the Fed will again support risk assets as it did during the disinflationary era. He favors valuation discipline and idiosyncratic returns over broad market exposure, with smaller initial positions and selective additions as conviction grows.