Fed rate hike: The Fed seems more optimistic than some investors. Here’s why

At Wednesday’s Federal Reserve meeting, along with warnings of further pain, policymakers laid out a hopeful scenario in which they could gently ease inflation while the economy remains resilient, albeit weakened.

Not everyone in the market agrees.

In particular, traders and analysts closely watching the direction of interest rates said they were bracing for a more dire outcome than the Fed had predicted.

“The market thinks the Fed’s economic projections are an unrealistic fantasy,” said Mark Cabana, head of U.S. rates strategy at Bank of America.

Interest rate traders have been nervous this year as the Fed’s forecast for inflation and interest rates has been repeatedly raised by reality. The central bank raised interest rates by three-quarters of a percentage point this week – the third such increase since June. The Fed’s policy rate is now at its highest level since 2008, well above forecasts at the start of the year. And policymakers predict it will rise further as the central bank steps up its campaign to bring down stubbornly high inflation.

After the Fed announced its decision, traders responded quickly, adjusting prices in a number of interest rate markets such as government bonds and futures to reflect the new high. But the alignment of the market with the central bank ended here.

On the contrary, the market prices reflect the expectations of many analysts. While the Fed doesn’t predict it will cut interest rates until 2024 at the earliest, analysts are betting the central bank will have to do so next year. Aggressive interest rate hikes by the Fed are widely believed to push the US economy into recession, reduce economic growth and push inflation down faster than the central bank has forecast. That, in turn, is likely to force the Fed to shift its focus from fighting inflation and start cutting interest rates by the end of next year to support the ailing economy.

“The market thinks the economy will slow faster than the Fed does,” Cabana said. “The market thinks it will slow inflation faster than the Fed. The market believes that this will cause the Fed to focus on stimulating growth from fighting inflation.

Stocks fell on Friday, posting a second straight weekly loss, as investors pulled $4 billion out of funds that bought U.S. stocks in the seven-day period ending Wednesday, according to data provider EPFR Global.

Higher interest rates increase costs for companies and consumers, usually affecting stock prices. The Fed was not the only central bank to raise interest rates this week, with policymakers in Europe and Asia moving in tandem.

“It’s likely we’ll end up with the economic situation the Fed is predicting,” said Kate Moore, managing director at BlackRock.

In particular, analysts said the Fed’s expectation of an acceleration of economic growth next year, from a forecast of 0.2% for 2022 to 1.2%, is inconsistent with such sharply higher interest rates. Analysts at Barclays said the growth outlook was “difficult to reconcile” with slowing spending and “intensification of tightening financial conditions”. As higher rates raise costs for companies, spending falls, hiring slows and unemployment rises.

The Fed hopes that it can simply shut down jobs without significantly increasing unemployment. However, some analysts doubt that the unemployment rate will remain as low as the Fed’s forecast of 4.4% at the end of next year. TD Bank predicts unemployment will be 4.8% at the end of next year. Bank of America expects 5.6%.

Their worse economic outlook means that analysts expect inflation to fall more quickly, with a recession reducing consumer and business demand faster than a milder slowdown. It also paves the way for the Fed to cut interest rates to support the economy, which it has said it will do once it is confident inflation will return to its 2% target.

Futures currently forecast a rate of around 4.5% at the end of 2023, down from a peak of 4.7% earlier this year, and imply a quarter-point decline in the back half of the year.

However, not everyone agrees with the market’s pricing. Goldman Sachs’ forecasts closely match those of the Fed, and the bank’s analysts predict that interest rates will remain high over the next year, making it harder to curb inflation. Lauren Goodwin, an economist at New York Life Investments, said she also expects inflation to remain well below the Fed’s long-term target of 2%, as the central bank considers cutting interest rates. Instead, Goodwin said, the market’s hope for lower interest rates is “optimistic and I think very optimistic.”

Part of the challenge for the Fed is to accurately predict how interest rate hikes, along with many other global forces, will affect the economy. Along with other central bank actions, Russia’s war with Ukraine continues to weigh on food and energy prices, despite supply chain constraints that fueled inflation during the pandemic remaining and some emerging economies teetering on the brink of crisis.

Members of the Fed’s monetary policy committee have acknowledged such uncertainty. In their predictions, they are asked to “indicate your judgment of the uncertainty added to your predictions relative to levels of uncertainty over the past 20 years,” with anonymous responses being a binary choice between higher or lower. All participants answered “higher” across all forecasts – GDP, inflation and unemployment – for the first time since March 2020 and the start of the coronavirus crisis.

“We don’t know — nobody knows — whether this process will lead to a recession or, if so, how significant that recession will be,” Fed Chairman Jerome Powell said on Wednesday.

For Cabana, such a high level of uncertainty, along with such rapid rate hikes designed to stifle the economy, is a cause for concern.

“We just think the Fed is reflecting that they have maximum uncertainty about how the economy is going to develop,” he said. “If you drive a car at 75 mph with uncertainty about where the road is going, the chances of an accident are pretty high.”

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