Are Markets Being Too Aggressive Pricing in Fed Rate Hikes?

Posted by lplresearch

Tuesday, October 19, 2021

At next week’s Federal Open Market Committee (FOMC) meeting, the Committee will likely need to reconcile its members’ views of when interest rate hikes should begin with the market’s ever changing view. After the September FOMC meeting, the Committee released its dot plot, which shows how individual Committee members were thinking about the path of short-term interest rates over the next few years. The Committee was evenly split between rate hikes beginning in late 2022 or beginning in early 2023. However, since the voting members were generally more dovish than the median dot plot would suggest, rate hikes were assumed, at least in our view, to start early 2023. However, renewed concerns about inflation have the market challenging that view.

“The Fed is in a difficult situation right now,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “Do they raise rates to address inflation concerns, potentially choking off economic growth? Or do they continue to let inflation run hotter than it has historically to let the economy continue to recover? We think the Fed is likely to be more patient in raising rates than markets are currently expecting.”

As seen in the LPL Research Chart of the Day, markets have pulled forward the timing and the path of interest rate hikes recently. Currently (blue line), the futures-implied rate for the fed funds rate has shifted considerably and is now pricing in two rate hikes in 2022 and nearly three hikes in 2023. A month ago (orange line), one hike was priced in for 2022 and another two for 2023. To be sure, inflation rates have stayed higher and persisted longer than many, including central bankers globally, thought several quarters ago. Moreover, a number of market-based inflation expectations have hit their highest levels in decades. In return, financial markets think the Committee may have to act sooner than anticipated back in September to keep inflation from becoming untethered to long-term expectations.

View enlarged chart.

However, we think the market has moved too aggressively in pricing in rate hikes. Structural factors continue to point to low inflation longer term despite what is likely to be persistently high inflation into the first half of 2022. Additionally, those same market-based inflation expectations that show concern about near-term inflation revert back to normal levels longer term. Finally, aggressively raising interest rates likely won’t help with the supply-driven shocks that are currently causing many of the inflationary pressures. In fact, hiking too aggressively may negatively impact demand at a time when some of the supply-side challenges could be abating, which could then be disinflationary—something the Fed is rightly concerned about. Nonetheless, we’re likely going to continue to hear about inflation and what the Fed should or shouldn’t do. In the meantime, we’re likely to see some additional volatility in the rates markets—particularly in the front end of the yield curve—until this inflation debate is settled (which isn’t likely to be anytime soon).


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