Fed message that rates will be on hold for 'a while' clashes with bets on 2023 rate cut

Fed message that rates will be on hold for ‘a while’ clashes with bets on 2023 rate cut

(Bloomberg) – Federal Reserve Chairman Jerome Powell has history on his side as he and his colleagues part ways with Wall Street on how long interest rates will stay high in 2023.

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After the fastest monetary policy tightening since the 1980s, the central bank is expected to raise its benchmark rate by 50 basis points on Wednesday in a downgrade after four straight moves of 75 basis points to rein in inflation.

Such a move – widely flagged by officials – would take rates to a target range of 4.25% to 4.5%, the highest level since 2007. They are also expected to signal further tightening of 50 basis points the next month. next year, according to economists polled by Bloomberg. , and an expectation that once they reach that peak, they will remain on hold throughout 2023.

Financial markets agree on the short-term view, but see a rapid pullback in peak rates later next year. This conflict could be because investors expect price pressures to subside faster than the Fed, which fears inflation will turn out to be sticky after being burned by a bad call, it would be transitory. . It could also reflect bets that rising unemployment will become a bigger concern for the Fed.

This week’s meeting in Washington is yet another opportunity for Powell to emphasize that officials expect to keep rates high to beat inflation – as he did in a Nov. 30 speech when he stressed that the policy would remain restrictive “for some time.”

Over the last five interest rate cycles, the average hold at a peak rate was 11 months, and these are periods when inflation was more stable.

“The Fed has sent the message that the key rate should remain at its maximum level for some time,” said Conrad DeQuadros, senior economic adviser at Brean Capital LLC. “That’s the part of the message that the market still hasn’t gotten. Estimates of how far inflation will fall are overly optimistic.

Two distinct views of the post-pandemic economy are at play in the tension between Fed communication and investors: The market view shows a credible central bank quickly putting inflation on track to its 2% target , perhaps with the help of a mild recession or disinflationary forces that have kept prices low for two decades.

Financial markets “just price in a normal business cycle,” said Scott Thiel, chief fixed income strategist at BlackRock Inc, the world’s largest asset manager.

A competing view indicates that supply constraints will be an inflationary force for months, if not years, as redrawn supply lines and geopolitics affect critical inputs of workforce chips and talent oil and other raw materials.

In this thesis, central banks will be wary of progress on inflation, which may be only temporary and may be vulnerable to the emergence of new frictions that prolong price pressures.

“Strategic competition” is inflationary, says Thiel. “We expect inflation to be more persistent, but we also expect volatility in inflation, and for that matter economic data more broadly, to be higher.”

Swap traders are currently betting that the funds rate will hit just under 5% in the May-June period, with a full quarter-point cut around November and the key rate ending next year at about 4.5%.

This would mark an unusually quick declaration of victory over inflation which is now three times higher than the Fed’s 2% target.

“The futures curve is a manifestation of the success or failure of the FOMC’s communications policy,” said John Roberts, the former Fed Board chief macro-modeler who now knows how to run a blog and consult investment managers, referring to the Federal Open Market Committee.

It’s not just the timing of the start of the cuts, but the amount that money market traders see coming that exceeds historical norms. According to Citigroup Inc., the more than 200 basis points of upcoming Fed rate cuts now priced into futures markets are the farthest ahead of any round of policy easing until 1989.

Futures contracts imply a Fed rate cut ending around mid-2025, according to data from Bloomberg.

Fed officials have not completely ruled out a rapid deceleration in inflation. New York Fed President John Williams said he expects the inflation rate to halve next year to around 3% to 3.5%.

Property price inflation has started to ease, and lower rates for new leases on homes and apartments should eventually translate into lower reported housing costs. Services prices, less energy and housing, a benchmark highlighted by Powell in a recent speech, slowed in October.

Investors are also optimistic about price pressures. Prices for inflation swaps and Treasury inflation-protected securities predict a sharp drop in consumer prices next year.

But there are also signs that the road back to the Fed’s 2% target could be long and bumpy.

Employers added jobs at a rate of 272,000 per month over the past three months. That’s slower than the average of 374,000 over the previous three months, but still robust and one of the reasons demand is holding up.

Historically, Fed officials note, there is a sticky quality to inflation, which means it takes a long time to extract it from the millions of pricing decisions businesses and households make every day.

They also measure the achievement of their policy as guaranteeing inflation of 2%, not 3%, and may be reluctant to start cutting borrowing costs if inflation remains stuck above their target.

Williams, for example, said he expects no reduction in the benchmark lending rate until 2024, although he expects inflation measures to fall next year.

“People like to focus on things coming back to where they were. But the trend “to higher rates ‘may last for a while,'” said Kathryn Kaminski, chief research strategist and portfolio manager at AlphaSimplex Group. “It’s something people underestimate.”

–With help from Alex Tanzi and Simon White.

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