Jerome Powell, Federal Reserve Chair, has history to his side. He and colleagues have split with Wall Street over whether interest rates should remain high in 2023.
After four straight 75-basis point moves to curb inflation, the central banks is poised to increase its benchmark interest rate by 50 basis points on Wednesday. It was the fastest ever tightening of the monetary policy since 1980s.
Such a move — widely flagged by officials — would lift rates to a 4.25% to 4.5% target range, the highest level since 2007. They’re also likely to signal another 50 basis points of tightening next year, according to economists surveyed by Bloomberg, and an expectation that once they reach that peak, they’ll stay on hold through all of 2023.
The near-term vision is agreed upon by financial markets, but they expect a sharp retreat from peak rates in the next year. The reason for this clash is that investors expect price pressures and the Fed to ease more quickly than they do. Fed fears inflation will become permanent after being burned by a poor call. This could be due to the fact that Fed worry about rising unemployment.
This week’s meeting in Washington is a fresh opportunity for Powell to hammer home his point that officials expect to hold rates high to defeat inflation — as he did in a Nov. 30 speech when he stressed policy would stay restrictive “for some time.”
Over the last five cycles of interest rate cycles, the average stay at a peak rate was eleven months.
“The Fed has been pushing the message that the policy rate is likely to remain at its peak rate for a while,” said Conrad DeQuadros, senior economic adviser at Brean Capital LLC. “That is the part of the message that the market has consistently not gotten. The estimates of the degree to which inflation will come down are too optimistic.”
There are two different visions of the post-pandemic economy that are at the center of the tension between Fed communication to investors. The market view shows a credible central banks quickly setting inflation on a path towards its 2% target. This could be possible with the aid of mild recessions or disinflationary forces which kept prices low for decades.
Financial markets “are simply pricing in a normal business cycle,” said Scott Thiel, chief fixed income strategist at BlackRock Inc, the world’s largest asset manager.
Competitors view Supply constraints will cause inflation over months, if not years, as geopolitics and redrawn supply line affect critical inputs like chips and workers talent to oil and any other commodities.
This thesis suggests that central banks should be cautious about inflation progress, as it may be temporary and vulnerable to new frictions that could cause price pressures to persist.
“Strategic competition” is inflationary, says Thiel. “We expect inflation to be more persistent but also expect the volatility of inflation, and for that matter economic data more broadly, to be higher.”
Swaps traders are currently betting that the funds rates will peak at just under 5% in May-June, with a quarter point reduction occurring by November. The policy rate will then end next year around 4.5%.
That would mark an unusually quick declaration of victory over inflation that is now running three times higher than the Fed’s 2% target.
“The futures curve is a manifestation of the success or failure of the FOMC’s communication policy,” said John Roberts, the Fed Board’s former chief macro modeler who know now runs a blog and consults investment managers, referring back to the Federal Open Market Committee.
It’s also not only the timing for the start of cuts but just how much money market traders see coming that is beyond the historic norms. Citigroup Inc. says that the Fed’s upcoming rate cuts of over 200 basis points are now priced into futures markets, far more than any previous policy easing cycle.
Bloomberg data shows that futures contracts could indicate a Fed rate cut ending in mid-2025.
Fed officials haven’t completely ruled out a quick deceleration in inflation. John Williams, New York Fed president said He anticipates that the inflation rate will be about 3% to 3.5% in next year.
The slowing of inflation in goods prices has led to a cooling trend. Lower reported shelter costs should be attributed to the softening of rates for new apartments and homes leases. Services prices, minus shelter and energy (a benchmark Powell recently highlighted) declined in October.
Investors also believe that price pressures will be reduced. Inflation Swaps Pricing and Treasury Inflation Protected Securities Predict sharply falling consumer prices next year.
But there are also signs that the road back to the Fed’s 2% goal could be long and bumpy.
Over the past three months, employers added jobs at a rate of 272,000 per month. That’s slower than the 374,000 average in the previous three months, but still robust and one reason why demand is holding up.
Fed officials have noted that inflation has been sticky in the past. This means it can take a while to get it out of the many pricing decisions households and businesses make every day.
They may also be focusing on securing at least 2% inflation as the goal of their policy and not 3%. In this case, they might be reluctant to begin reducing borrowing costs, if inflation rises above their target.
Williams, for example, said he doesn’t expect any cuts in the benchmark lending rate until 2024 even though he expects a decline in inflation measures next year.
“People like to focus on things going back to where they were. But the trend” of higher rates “can last for quite a while,” said Kathryn Kaminski, chief research strategist and portfolio manager at AlphaSimplex Group. “That’s something people are underestimating.”
–With assistance from Alex Tanzi and Simon White.
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