Investors are betting on a longer period of higher interest rates as they begin to accept the message from US Federal Reserve officials that more time is needed to cool inflation in the face of a resilient labour market.
Pricing in the futures market shows that investors expect rates to peak slightly above 5 per cent in July, with only one interest rate cut by year-end. As recently as last week, they had been expecting a peak of around 5 per cent in May, with two interest rate cuts by the end of 2023.
The shift came after a blockbuster employment report which showed the labour market surged by half a million jobs in January.
Investors have for months been wagering that a rapid deceleration in inflation would allow the Fed to cut interest rates as soon as the fourth quarter of this year, despite the insistence of central bank officials that they had no plans to do so.
Some market watchers, including Morgan Stanley, had bet that the Fed’s 0.25 percentage point increase on February 1 would be its last.
But those expectations have recently deflated as investors’ bets on where inflation will be in a year’s time have ratcheted up — from about 2.4 per cent before the jobs report to 3.9 per cent as of Friday, according to Refinitiv data.
The shift in interest rate expectations takes investors closer to the Fed’s official projections which were published in December, although they still underestimate the central bank’s expectation that it will not cut interest rates until at least 2024.
This week a series of senior US monetary policymakers sought to reinforce the Fed’s message, insisting that they did not expect a quick end to their policy tightening.
Christopher Waller, a Fed governor, said on Wednesday: “Some believe that inflation will come down quite quickly this year. That would be a welcome outcome. But I’m not seeing signals of this quick decline in the economic data, and I am prepared for a longer fight to get inflation down to our target.”
Also on Wednesday, John Williams, president of the New York Fed, said: “We need to retain a sufficiently restrictive stance of policy. We’re going to need to maintain that for a few years to make sure we get inflation to 2 per cent.”
But even though markets are now more aligned with the Fed’s projections, some economists worry that the central bank is not giving sufficiently clear guidance about its policy path.
After the last FOMC meeting, Jay Powell, the Fed chair, struck a more dovish tone — before reverting to a position that appeared to be more hawkish this week.
“I think the Fed is taking a big risk by not dictating the narrative,” said Gregory Daco, chief economist at EY Parthenon. “The Fed is exposing itself to rapid and significant market pivots.”
Tuesday’s release of January’s consumer price index will be the latest test of the Fed’s resolve as it will provide key evidence of whether the pace of price growth is slowing.
In December, headline inflation increased at an annual rate of 6.5 per cent, or 5.7 per cent on a core basis which strips out volatile food and energy costs. Annual CPI hit a peak of 9.1 per cent in June last year.
Revisions to 2022 CPI data released on Friday added to economists’ concerns that inflation was not falling as fast as they had hoped.
“We continue to see the data as going in the right direction for the Fed across a range of metrics but at a potentially slowing pace and slightly higher level than had seemed to be the case a few months ago,” Peter Williams of ISI Evercore said.
“The market will likely and should, in our view, continue to reprice towards higher [rates] for longer given the shift in the data we’ve seen.”
Economists and Fed officials have been particularly worried that service sector inflation will prove to be more stubbornly hard to bring down than goods inflation.
“It’s probably going to be bumpy,” Powell said this week of the “disinflationary process” in an interview with David Rubenstein, the founder of Carlyle, the private equity group.
“If the data were to continue to come in stronger than we forecast, and we were to conclude that we needed to raise rates more than is priced into the markets or than we wrote down at our last group forecast in December, then we would certainly do that,” Powell said. “We would certainly raise rates more.”