The Fed and markets still disagree
The first major economic data point for February came out on Wednesday, as the Federal Reserve announced its latest rate hike. Please see the below for our take on the Fed’s policy actions and the divergence between the Fed and the market on the path for rates from here.
As had been widely expected, the Federal Reserve increased the Fed Funds policy rate on Wednesday by 25 b.p., to a range of 4.50%–4.75%. The accompanying statement acknowledged the fact that inflation “has eased somewhat,” but noted it is still too high. Another key change in the language of the statement was that it is no longer the “pace,” but instead now the “extent” of future increases, which will be the Fed’s focus going forward.
As in recent statements, the Fed stated that “ongoing increases in the target range will be appropriate,” suggesting more than one additional hike in the coming months. This differs from our economics team’s view, which anticipates only one more hike in March and then a pause. Likewise, the market is assuming only one more hike before the Fed pauses. Accordingly, one can read the Fed’s statement as hawkish versus the market. Yet we, the Fed, and the market will have two more employment reports and two more CPI prints to digest before the March meeting, which will tell us what’s likely to happen in the meetings that follow.
More importantly, the main divergence between the market and the Fed is not in the terminal rate of the cycle, but rather the timing and magnitude of rate cuts. The Fed’s forecasts show no expectation of rate cuts this year, which Chair Powell reiterated in his press conference, while the market is pricing in three 25 b.p. cuts by this time next year, starting this summer. Part of that could be the market being much more confident in inflation being on a sustainable downward path than the Fed is, while part could also have to do with the market pricing in a sharp decline in rates due to a recession. We expect the answer to lie somewhere in between the Fed’s and the market’s expectations for cuts. The market is too optimistic about a linear decline in inflation, but the Fed is too backward-looking in assuming that prices won’t fall sustainably for multiple quarters. That translates to a possibility of rate cuts in Q4, in our opinion, not as soon nor as aggressively as the market seems to expect.
Both the bond and equity markets interpreted the Fed’s press conference in a fairly dovish light, with both asset classes rallying. From a policy perspective, such rallies are counterproductive, as they continue the recent loosening in financial conditions at a time when the Fed is actively trying to tighten them to slow economic activity and bring inflation back to target.
We continue to expect that it will take both weaker labor markets and steadily lower inflation to sustain the rallies in both bonds and stocks. That makes the market vulnerable to strong labor market or inflation data. For the time being, bad news for the economy remains good news for the market and good news for the economy remains bad news for the market. Our first opportunity to re-test this framework is Friday with the January Employment Situation release at 8:30AM ET from the Bureau of Labor Statistics. More to come…
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