Investors and Federal Reserve officials are at odds over the path of US interest rates this year, widening the gap between policymakers’ forecasts and market expectations.
Markets suggested the central bank would back off and reverse its months-long campaign to raise interest rates, the most aggressive since the 1980s. Senior Fed officials have confirmed that they will stay.
The difference reflects confidence in future inflation, which has cooled in recent months but remains high by historical standards. “There’s a very clear disconnect and it’s a disconnect around inflation,” said Priya Misra, head of rates strategy at TD Securities.
Most Fed officials have agreed to raise the benchmark federal funds rate above 5 percent and keep it at that rate until at least the end of the year in order to cool the economy enough to control inflation.
Futures markets indicated that the Fed would hold off, capping policy rates between 4.75 percent and 5 percent, before implementing half of its interest rate cut of a percentage point from its peak rate in December. By the end of 2024 the fed funds rate will drop to 2.8 percent, according to market prices, about a full percentage point below what Fed officials projected in December.
Betting on lower rates has been rampant as investors have lowered their inflation expectations. On Friday, one-year US inflation swaps, a derivative contract that reflects inflation expectations a year from now, was 1.77 percent, the lowest level in more than two years, according to Refinitiv.
Another market measure, called the one-year break-even inflation rate, is currently at 2 percent.
Ajay Rajadhyaksha, head of global research at Barclays, said: “The market really believes that inflation will come down faster than the Fed expects. The Fed believes that inflation is very difficult to come down without weakening the labor market, but the market is not convinced.
Fed officials have sought to curb speculation that they will change course despite some favoring a cut in rate hikes to a quarter of a percentage point at their next meeting, which ends on February 1.
In the past week, senior policymakers – including Fed vice chairman Lael Brainard and the New York Fed’s John Williams – reiterated that the central bank would “stay the course” with further rate hikes.
The Fed’s preferred measure of inflation – the price index of core personal consumption expenditures – stood at 4.5 percent, down from a peak of 5.4 percent last year but more than twice the central bank’s 2 percent target.
Central bankers are particularly concerned about inflation in the services sector, which they worry will last longer than price pressures linked to commodity shocks triggered by the war in Ukraine and supply chain blockages linked to the Covid-19 pandemic.
“We don’t want to be false heads,” Christopher Waller, the Fed governor, said on Friday. He went on to say: “Inflation isn’t going to magically disappear. It’s going to be a slower and harder slog to get inflation down, so we need to keep rates down for longer and not start cutting rates at the end of the year.”
Market expectations do not mean consensus on Wall Street. “I don’t believe there will be a rate cut in 2023,” said Ron O’Hanley, chief executive of State Street, the US captive bank. “There will be moderate rate increases.”
However, many investors have been paying attention to recent data showing a slowdown in economic activity and other signs that US consumer spending is starting to take a hit.
“Markets are cutting prices because there is high confidence the data will 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, also added to the market’s confidence that inflation will fall significantly.
Jobs and wage data are “the last piece you need to be confident that the decline in inflation is sustainable”, said Eric Winograd, an economist at AllianceBernstein.
Still, Winograd said, “there is a lot of hope attached to the market’s expectations of a rapid decline in inflation”.
Additional reporting by Brooke Masters in New York