Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Tuesday, December 13, 2022
The Federal Reserve (Fed) is meeting this week and will likely increase short-term interest rates by 0.50% to bring the fed funds rate to 4.50% (upper bound). The 0.50% increase represents a step-down in the pace of hikes, though the cumulative increase to date ranks amongst the most aggressive increases since the 1980s. Along with the expected increase in interest rates, the Fed will also release updated forecasts for economic growth, inflation and interest rates. The “dot plot”, which is the individual committee member’s expectation of the appropriate fed funds rate each year, will likely show a terminal rate of around 5%, or potentially higher. While markets believe the Fed will hike rates to 5%, given the aggressive rate hikes already this year and the long and variable lag associated with said hikes, markets do not believe the Fed will hold rates at elevated levels for very long.
Despite assurances of an unwavering commitment to bring down inflationary pressures, markets continue to think the Fed will “pivot” or “pause” and cut rates in 2023 and into 2024. As such, markets have a very different view of monetary policy over the next few years, which the Fed may think is premature. The chart below shows market expectations for where the fed funds rate will end each year (orange line) versus the dot plot expectations with a pronounced divergence in 2024. While markets and Fed officials seemingly agree on the near term trajectory of the fed funds rate, markets expect the Fed to reduce interest rates by nearly 0.50% in 2023 and another 1.0% in 2024.
Historically, markets have done a pretty good job of predicting rate cuts, but with inflationary pressures still significantly above the Fed’s target, Powell may need to reset market expectations—again. Markets have rallied three times this year on the expectation of a more accommodative Fed. These three rallies ended when expectations for Fed moderation proved too early. This time the Fed has signaled it is on board with the market’s consensus for a 0.50% hike this week, but a hawkish press conference by Chair Powell could be a catalyst for some retracement. Moreover, if there is forceful pushback, similar to the type of pushback Powell provided at the Jackson Hole Symposium in August, we could see another leg up in yields. However, with the second softer-than-expected CPI release today, maybe the market is right. Could be an interesting Fed meeting tomorrow.
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