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Fed’s Message That Rates Will Stay on Hold for ‘Some Time’ Clashes With 2023 Rate-Cut Bets

Traders are pricing in Fed rate cuts in second-half of 2023

Economists wary of rising inflation volatility on new scarcity

By
Craig Torres and
Liz McCormick
12 December 2022 at 2:00 am AEDTUpdated on12 December 2022 at 11:16 am AEDT

Federal Reserve Chair Jerome Powell has history on his side as he and colleagues split with Wall Street over how long interest rates will stay high in 2023.

After the fastest tightening of monetary policy since the 1980s, the central bank looks set on Wednesday to increase its benchmark rate by 50 basis points in a downshift after four straight 75 basis-point moves to curb inflation.

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.

Financial markets agree on the near-term vision, but see a rapid retreat from peak rates later next year. That clash could be because investors expect price pressures to ease faster than the Fed, which worries inflation will prove sticky after getting burned by a bad call it would be transitory. It could also reflect bets that rising unemployment will become a more weighty Fed concern.

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.”
'For Some Time'

Average rate between peak rate and first cut is 11 months
Source: Bloomberg

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

“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.”

At play in the tension between Fed communication and investors are two distinct visions about the post-pandemic economy: The view in markets shows a credible central bank quickly putting inflation on a path to its 2% goal, possibly with the help of a mild recession or disinflationary forces that kept prices low for two decades.

The yield curve — as measured by the gap between 10- and 2-year Treasury yields — is inverted by the most since the 1980s, a signal traders see an economic downturn ahead.

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.

A competing view says supply constraints will be an inflationary force for months and maybe years as redrawn supply lines and geopolitics affect critical inputs from chips and workforce talent to oil and other commodities.

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

“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 currently bet the funds rate will crest just under 5% in the May-June period, with a full quarter point reduction coming through by around November and the policy rate ending next year at about 4.5%.

The projected Fed rates path would mark an unusually quick declaration of victory over inflation that is now running three times higher than the Fed’s 2% target.

Source: Bloomberg

“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 with investment managers, referring 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. The over 200 basis points of upcoming Fed rate reductions now priced into futures markets is the most ahead of any policy easing cycle back through 1989, according to Citigroup Inc.

Futures contracts imply the Fed will call a halt to rate cuts around mid-2025, according to Bloomberg data.
Magnitude of Needed Cuts

Eurodollar futures markets pricing in large scale upcoming cuts
Source: Citibank

Fed officials haven’t completely ruled out a quick deceleration in inflation. John Williams, the New York Fed president, said he expects the rate of inflation to halve next year to about 3% to 3.5%.

Goods price inflation has started to cool off and softening rates for new leases on homes and apartments should eventually feed into lower reported shelter costs. Services prices, minus energy and shelter, a benchmark highlighted by Powell in a recent speech, decelerated in October.

Investors are also optimistic on price pressures. Pricing in inflation swaps and Treasury Inflation Protected Securities predict consumer prices falling sharply next year.

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

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

Historically, Fed officials note, there is an sticky quality to inflation, meaning it takes a long time to wring it out of the millions of pricing decisions businesses and households make each day.

They are also measuring the achievement of their policy as securing 2% inflation, not 3%, and may be reluctant to start reducing borrowing costs if inflation gets stuck 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.”