(Bloomberg) — Federal Reserve Chairman Jerome Powell has history on his side as he and his colleagues split with Wall Street on how high interest rates should stay in 2023.
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After the fastest tightening of monetary policy since the 1980s, the central bank is set to raise rates by 50 basis points, marking the end of four straight 75-point moves to curb inflation.
Such a move, widely noted by officials, would raise rates to a target range of 4.25% to 4.5%, the highest level since 2007. According to economists polled by Bloomberg, they point to another 50 basis points of tightening next year. , and an expectation that they will remain dormant until 2023 after reaching this peak.
Financial markets agree with the near-term vision, but see a rapid pullback from peak rates later next year. The clash may be due to investors expecting price pressures to ease faster than the Fed, which is concerned that inflation will be sticky after being fueled by the bad call that it will be transitory. It could also reflect bets that rising unemployment will become a more serious concern for the Fed.
This week’s meeting in Washington is another opportunity for Powell to underscore his view that officials expect to keep rates high to beat inflation — as he did in a Nov. 30 speech when he stressed that policy would remain restrictive “for some time.”
Over the past five interest rate cycles, the average hold at the peak rate was 11 months, and these were periods when inflation was more stable.
“The Fed is sending a message that the policy rate will remain at its peak for some time,” said Conrad DeQuadros, chief economic adviser at Brean Capital LLC. “That’s part of the message that the market is consistently not getting. Estimates on how much inflation will fall are very optimistic.”
The tension between Fed communications and investors has two divergent views on the post-pandemic economy: The outlook in markets suggests a credible central bank that will quickly push inflation back to its 2% target, possibly with the help of a mild recession. or the disinflationary forces that kept prices low for two decades.
Financial markets are “just pricing in a normal business cycle,” said Scott Thiel, chief fixed-income strategist at BlackRock Inc., the world’s largest asset manager.
A competing view says that supply constraints will drive inflation for months and possibly years as redrawn supply lines and geopolitics affect critical inputs from chips and labor to oil and other commodities.
In this thesis, central banks will be wary of inflationary progress, which may only be temporary and vulnerable to the emergence of new frictions that lead to prolonged price pressures.
Thiel says the “strategic competition” is inflation. “We expect inflation to be more sustainable, but we also expect inflation volatility and, for that matter, economic data more broadly to be higher.”
Swap traders are currently betting that the funds rate will rise to just below 5% in the May-June period, a full quarter-point cut by November, and the policy rate to end next year at around 4.5%.
That would mark an unusually swift declaration of victory over inflation, which is now three times the Fed’s 2% target.
“The futures curve is a reflection of the success or failure of the FOMC’s communication policy,” said John Roberts, a former Fed Board chief macro modeler who now runs a blog and consults with investment managers, referring to the Federal Open Market Committee.
It’s also not only the timing of the cuts to start, but it’s also outside the historical norms of how much money market traders have seen coming in. More than 200 basis points of the Fed’s impending rate cuts, now priced in futures markets, are the most ahead of any policy easing period since 1989, according to Citigroup Inc.
According to Bloomberg data, futures contracts call for a Fed rate cut in mid-2025.
Fed officials have not completely ruled out a sharp slowdown in inflation. New York Fed President John Williams said he expects inflation to halve next year to around 3% to 3.5%.
Commodity price inflation has begun to cool, and softening rates for new rents in houses and apartments should ultimately lead to lower shelter costs. Service prices, negative energy and shelter, a benchmark highlighted by Powell in his last speech, slowed in October.
Investors are also optimistic about price pressures. Prices on inflation swaps and Treasury Inflation-Protected Securities predict that consumer prices will fall sharply next year.
But there are also signs that the path to the Fed’s 2% target could be long and difficult.
Employers added jobs at a monthly pace of 272,000 over the past three months. That’s slower than the previous three-month average of 374,000, but still solid and one reason demand is holding back.
Historically, Fed officials note, inflation has had a sticky quality, meaning it takes a long time to untangle it from the millions of pricing decisions businesses and households make every day.
They also see the achievements of their policies as delivering inflation of 2% rather than 3%, and may be reluctant to start reducing borrowing costs if inflation remains above their targets.
For example, Williams said he does not expect any reduction in the benchmark lending rate until 2024, although he expects inflation measures to ease next year.
“People like to refocus. Kathryn Kaminski, chief research strategist and portfolio manager at AlphaSimplex Group, said the trend toward higher rates “could continue for a long time.” “It’s something people underestimate.”
–With assistance from Alex Tanzi and Simon White.
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