Markets

The Fed has two more rate hikes left, according to markets

The Federal Reserve (Fed) sees no rate cut in 2023, according to recent minutes. However, markets are predicting top rates as soon as spring. Markets currently see the most likely path as two more small increases, specifically a 0.25 percentage point increase on February 1st and a similar 0.25 percentage point increase on March 22nd. The Fed does not plan to end hikes so soon, based on a recent projection.

Fed Forecasts

At the Fed’s December meeting, policymakers released forecasts for rate levels in 2023 via the Fed’s Summary of Economic Projections. Only two of the Fed’s nineteen policymakers see rates staying below 5% in 2023. The base case for markets is currently more of an edge case for the Fed.

Conversely, markets, as summarized by the CME FedWatch Tool, expect rates not to exceed 5% at all, and if they do, any period of above 5% rates may be short. Based on December projections, the Fed sees at least one more hike than the market, perhaps two.

Markets and the Fed aren’t too out of sync in expectations right now, but markets see top rates at 0.25-0.5 percentage points below what the Fed suspects they might peak.

Inflation data

The difference in expected rates could come down to inflation projections. Markets may suspect that inflation reports will continue to be favorable in the coming months. The Fed would of course be happy about that too, but they have repeatedly stressed that they need to see more evidence that inflation is actually returning to the 2% level and not just falling from recent highs. The Fed also wants wage growth to be cool and more evidence that corporate margins are shrinking. As such, markets may see a continuation of encouraging inflation reports and related data, which the Fed is not yet willing to speculate on.

Recession risk

The bigger concern is the recession. The Fed sees a soft landing for the economy in this interest rate cycle as most likely. That may be optimistic. Many economic indicators point to a recession in 2023, even though the labor market is still holding up remarkably well.

As such, the other major scenario that could lead to a convergence between the Fed’s current forecasts and market expectations is a recession. A recession can reduce inflation, but also prompt the Fed to lower rates to spur economic growth.

Peak interest rates

The Fed and markets doubt that peak rates for the US economy are approaching. However, the Fed generally sees one or two more hikes in 2023 than the market does, currently taking rates materially above 5%, while markets are uncertain that rates will exceed 5%.

Optimistically, this may be because inflation data will move better than the Fed currently anticipates. However, more pessimistically, there is a risk that the difference between the forecasts is a risk of recession. A recession in 2023 may force the Fed to demand a rate cut. Either way, both markets and Fed policymakers believe we are close to six-month highs.

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