At the Federal Reserve’s meeting on Wednesday, along with warnings of pain to come, policymakers outlined a hopeful scenario in which they would be able to moderate inflation while the economy, albeit weakening, remained resilient.
Not everyone in the market agrees.
In particular, traders and analysts closely watching the direction of interest rates said they were bracing for a worse outcome than the Fed had anticipated.
“The market thinks the Fed’s economic forecasts are an unrealistic fantasy,” said Mark Cabana, head of U.S. rates strategy at Bank of America.
Interest rate traders have been rattled this year as the Fed’s outlook for inflation and interest rates has been repeatedly overturned by reality. The central bank raised interest rates by three-quarters of a percentage point this week – the third such increase since June. The Fed’s key interest rate is now the highest since 2008, well above forecasts at the start of the year. And policymakers predict it will move even higher as the central bank escalates its campaign to reduce stubbornly high inflation.
After the Fed announced its decision, traders quickly reacted, adjusting prices across a range of interest rate markets, such as government bonds and futures, to reflect the new higher path. But that ended the convergence of the market with the central bank.
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Instead, market prices reflect what many analysts expect will happen. Although the Fed does not expect to cut interest rates until 2024 at the earliest, analysts are betting that the central bank will have to do so next year. The Fed’s aggressive rate hikes are believed to plunge the U.S. economy into recession, slow economic growth and drag inflation down faster than the central bank predicts. That, in turn, is likely to force the Fed to focus on fighting inflation and start cutting interest rates by the end of next year to support the ailing economy.
“The market thinks the economy will slow faster than the Fed,” Cabana said. “The market thinks it will slow inflation faster than the Fed. And the market thinks this will cause the Fed to shift from tackling inflation to stimulating growth.
Stocks fell sharply on Friday for a second straight week of losses as investors pulled $4 billion from funds that buy U.S. stocks in the seven-day period ending Wednesday, according to EPFR Global, a data provider.
Higher interest rates increase costs for companies and consumers, which usually affects stock prices. And the Fed wasn’t the only central bank to raise interest rates this week policy makers across Europe and Asia they all move in tandem.
“We are likely to end up in a worse economic situation than the Fed is currently predicting,” said Kate Moore, chief executive of BlackRock.
In particular, analysts said the Fed’s expectation of economic growth accelerating next year to 1.2 percent from a forecast of 0.2 percent for 2022 is at odds with such dramatically higher interest rates. Analysts at Barclays noted that the growth projection was “difficult to reconcile” with a slowdown in spending and the “increasing drag of tightening financial conditions”. As higher rates raise costs for companies, spending falls, hiring slows and unemployment rises.
The Fed hopes that it can simply extinguish jobs without significantly increasing unemployment. Still, some analysts doubt the unemployment rate will be able to stay as low as the Fed’s forecast of 4.4 percent at the end of next year. TD bank forecasts unemployment at 4.8 percent at the end of next year. Bank of America expects 5.6 percent through the end of 2022.
Their weaker economic outlook means analysts expect inflation to fall faster, with the recession reducing consumer and business demand faster than a milder slowdown. It also paves the way for the Fed to cut interest rates to support the economy, which it has said it will do only when it is confident inflation is heading back toward its two percent target.
Futures prices currently forecast a rate of around 4.3 percent at the end of 2023, down from a high of around 4.6 percent at the start of the year, marking a cut of just one quarter point in the back half of the year.
Still, not everyone agrees with what the market is valuing. Goldman Sachs’ forecasts are closely aligned with those of the Fed and the bank, with analysts predicting that interest rates will remain elevated throughout next year, with inflation proving difficult to contain. Lauren Goodwin, an economist at New York Life Investments, said she also expects inflation to remain too far from the Fed’s long-term target of two percent for the central bank to consider cutting interest rates. Instead, Ms Goodwin said, it is the market’s hope for lower rates that is “optimistic and I think too optimistic”.
Part of the challenge for the Fed is to accurately predict how rate hikes will affect the economy with so many other global forces at play. In addition to actions by other central banks, Russia’s ongoing war with Ukraine continues to weigh on food and energy prices, even as supply chain constraints that fueled inflation during the pandemic remain and some emerging economies are on the brink of crisis. .
Members of the Fed’s policymaking committee acknowledged the uncertainty. In their forecasts, they are asked to “indicate your judgment of the uncertainty associated with your projections relative to the levels of uncertainty over the past 20 years,” with anonymous responses being a binary choice between higher or lower. All participants across all forecasts – GDP, inflation and unemployment – responded “higher”, which happened for the first time since March 2020 and the onset of the coronavirus crisis.
“We don’t know — nobody knows — whether this process will lead to a recession, or if it does, how significant that recession would be,” Fed Chairman Jerome H. Powell said Wednesday.
For Mr. Cabana, such high levels of uncertainty, coupled with such rapid interest rate hikes designed to choke the economy, are troubling.
“We just think the Fed is reflecting that they’re extremely uncertain about how the economy is going to play out,” he said. “If you were to drive a car at 75 miles an hour, unsure of where the road is going, you have a fairly high chance of an accident.”