Investors and Federal Reserve officials disagree over the course of US interest rates this year, widening the gap between policymakers’ forecasts and market expectations.
Markets suggest that the central bank will reverse and reverse its months-long campaign to raise interest rates, the most aggressive since the 1980s. Senior Fed officials insist it will remain steadfast.
The divergence reflects views on future inflation, which has cooled in recent months but remains high by historical standards. “There’s a clear decoupling and it’s a decoupling about inflation,” said Priya Misra, head of interest rate strategy at TD Securities.
Most Fed officials have agreed to raise the benchmark federal funds rate above 5 percent and maintain that level until at least the end of the year to cool the economy enough to bring inflation under control.
Futures markets are signaling that the Fed will pause briefly and hedge its policy rate between 4.75 percent and 5 percent before taking a rate cut of half a percentage point from peak levels by December. By the end of 2024, the Fed Funds rate will fall to just 2.8 percent, according to market prices, about a full percentage point below what Fed officials predicted in December.
Bets on lower interest rates have increased as investors lowered their inflation expectations. On Friday, the one-year US inflation swap, a derivative contract that reflects inflation expectations for a year from now, was at 1.77 percent, the lowest level in more than two years, according to Refinitiv.
Another market measure, called one-year break-even inflation, is currently at 2 percent.
Ajay Rajadhyaksha, Global Chair of Research at Barclays, said: “The market genuinely believes that inflation will come down faster than the Fed expects. The Fed believes it is very difficult for inflation to fall without the labor market softening, but the market is not convinced.”
Fed officials have sought to curb speculation that they will soon reverse course, though some prefer to slow the rate of increase to a quarter of a percentage point at their next meeting, which ends Feb. 1.
Over the past week, senior policymakers — including Fed Vice Chairman Lael Brainard and New York Fed’s John Williams — reiterated that the central bank “will stay on track” with further rate hikes.
The Fed’s preferred measure of inflation — the core price index for personal consumer spending — stands at 4.5 percent, down from last year’s peak of 5.4 percent, but more than double the target of 2 percent from the Federal Reserve. central bank.
Central bankers are particularly concerned about inflation in the services sector, which they say will take longer to wring out than price pressures related to the commodity shock caused by the war in Ukraine and supply chain blockages due to the Covid-19 pandemic. 19 pandemic.
“We don’t want to be fooled,” Christopher Waller, a Fed governor, said Friday. He later said: “Inflation will not miraculously melt away. It’s going to be a slower, more difficult slog to get inflation down, which is why we need to keep rates high longer and not start cutting rates towards the end of the year.”
Market expectations do not imply consensus on Wall Street. “I don’t believe there will be a rate cut in 2023,” said Ron O’Hanley, CEO of State Street, the U.S. custodian bank. “There will be a moderate pace of rate increases.”
However, many investors have been paying attention to recent data showing economic activity is slowing and other signs that US consumer spending is beginning to take a hit.
“The market is in the process of price cuts because there is a strong belief that the numbers are going to be weak,” said Kavi Gupta, co-head of rates trading at Bank of America.
The latest US employment data, which showed a slowdown in wage growth, has also contributed to the market’s belief that inflation will come down significantly.
The data on jobs and wages is “the last piece you needed to be convinced that the fall in inflation is sustainable,” said Eric Winograd, an economist at AllianceBernstein.
Still, Winograd said, “there is a lot of hope embedded in market expectations of a rapid fall in inflation.”
Additional reporting by Brooke Masters in New York