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The next FOMC meeting is on February 1, where the Federal Reserve will determine its next policy decision on interest rates. This article covers how markets expect the Fed to respond, what readers should watch for in terms of changes in the expected path and the potential second-order effects of those changes.
The current expectation is an increase in interest rates of +0.25%, with the market determining 100% certainty of this result, setting the policy rate at 4.5%-4.75%.
Source: CME FedWatch Tool
The Fed’s expected course for 2023 is to keep rates up, with several Fed Governors recently emphasizing the need to keep policy rates restrictive enough to ensure that inflation does not return after initial signs of slowing, as it did in the 1970s.
Source: CME FedWatch Tool
Source: CME FedWatch Tool
At Jerome Powell’s press conference on December 14, he said the following (emphasis added):
“So, as I said, it is important that the overall financial situation continues to reflect the policy restrictions implemented to bring inflation down to 2 percent. We think that the financial situation has improved a lot in the past year. But our policy actions can go through the financial situation. And that, in one, it affects economic activity, the labor market, and inflation. So what we control is the policy movement in the communication we do. The financial situation also anticipates, and reacts to, our actions.
“I would add that our focus is not on short-term movements, but on continuous movements. And many, many, of course, move financial conditions over time. I would say that the current decision has not been in a policy stance that is quite restrictive, so we say that there will be a corresponding increase.
Prices in Transitory Inflation
Global risk assets have been in rally mode to start the year, as market participants increasingly expect inflation fears that plagued financial assets in 2022 to ease in 2023 and beyond. While the optimistic expectation of reducing inflation will certainly be bullish for risk-assets – because it will result in lower interest rates – one would be wise to keep in mind the inflation forecast from the Fed, as shown below. . A return to the 2% target is almost certainly desirable.
Source: Robin Brooks
With inflation easing and policy rates remaining elevated, the market believes that “moderately restrictive” policy will materialize in 2023, with a 1.31% cut in 2024.
The rate cut expected in 2024 is priced in by the market
Once inflation becomes entrenched into consumer expectations and the labor market, history has shown that it takes a monumental effort from central banks to tighten policy rates to squash inflation.
As noted by Liz Ann Special from Charles Schwab, the 6-month change in inflation expectations is the largest since 2011, an indication that monetary tightening has begun to work towards the real economy.
Source: Liz Ann Special
With a 25 basis point rate hike all but confirmed tomorrow, markets will pay close attention to the content and tone of Chairman Powell’s speech on the future policy rate path. We believe that “higher for longer” is the tone that the Fed will continue to communicate with the market.
However, on a sufficiently long timeline, the untenable results are clear. Just ask the US Treasury about its projections…
Source: US Treasury
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