The big risk in Wall Street’s bet on interest rates

Federal Reserve officials and financial markets have very different views on how the US economy and its inflation rate will perform this year. Inflation data due to be released on Thursday morning in Washington might help resolve their differences.

US markets were up on Wednesday (Thursday morning our time) in anticipation that the data will show another fall in the inflation rate, with the overall sharemarket rising just over one per cent but the Nasdaq index, with its bias to technology stocks, up nearly two per cent. The index of the mega-tech companies, the New York FANG index, also ended two per cent higher.

Other risk assets, like Bitcoin, which has risen more than four per cent in the past week, and commodities like oil (up 3.5 per cent), copper (up 2.5 per cent) and iron ore (up two per cent) also rose solidly. It is, or at least was, a “risk-on” environment ahead of the data dump.

The markets and the Federal Reserve’s Jerome Powell beg to differ on the outlook for interest rates. That could change when US inflation data is released this week.
The markets and the Federal Reserve’s Jerome Powell beg to differ on the outlook for interest rates. That could change when US inflation data is released this week. Credit:AP

The performance of the markets fits with the thesis of financial market investors. They see, and have priced in, US official interest rates rising to just under five per cent by June (the Fed is currently targeting a range of 4.25 per cent to 4.5 per cent) before falling back to 4.5 per cent by year-end.

The premise for that pricing is that the inflation rate, which peaked at 9.1 per cent in June last year and has steadily trended down since, will continue to slide as the US enters recession. The headline inflation rate was 7.1 per cent in November and the consensus expectation of market economists is for a rate of 6.5 per cent when the December numbers are revealed on Thursday.

The Fed view, which its officials have been promoting vigorously, is that the historically low unemployment rate of 3.5 per cent and continuing pressures in the services sector of the economy work against lower energy prices and reducing inflation in the goods sector to keep inflation unsustainably high.

The Fed consensus is that the federal funds rate (broadly equivalent to the Reserve Bank’s cash rate) will peak just above 5 per cent but remain there throughout this year.

The officials fret that the markets’ more optimistic outlook for inflation and interest rates – bond yields have been falling and sharemarkets rising since late October – will work against its efforts to tighten monetary conditions and get inflation sustainably under control and tracking towards its target rate of two per cent. That could lead to the Fed raising its policy rate by more than it otherwise would.

Obviously, the markets and the Fed can’t both be right and which view is supported by the data this year and prevails matters for the US and global economies and for markets.


In the immediate future, if the markets’ expectations of another material fall in the rate are borne out, it is probably that the Fed would choose to lift the upper end of its targeted range by only 25 basis points when it next meets at the end of this month. That would keep the markets’ thesis that US rates will be falling in the second half of the year alive.

If the data disappoints and shows higher-than-anticipated inflation, it is probable that meeting will raise the federal funds rate by 50 basis points. The Fed’s view that the federal funds rate will shift above five per cent and still be there at the end of the year will be buttressed.

That wouldn’t be good news for investors, given that the countervailing view is already priced into shares, bonds and other risk assets.

The outcomes aren’t, of course, just about the financial markets. The Fed seems to be convinced that it will take a material rise in unemployment and, inevitably, a recession to drive inflation out of the economy. The markets are convinced a recession is predestined.

The risk is one of over-kill. The Fed was wrong about the trajectory of inflation when it was on the way up, erroneously believing it would be “transitory.”

It could, given the lag between monetary policy decisions and their real-world effects, as easily be as wrong about the pace at which inflation falls, tipping the US into an unnecessarily severe recession rather than the “softish landing” that financial markets still think is possible.

There are Fed officials who believe that, while not necessarily altering its expectation of the “terminal” rate – the peak rate in this cycle – the Fed could use smaller increments (25 basis points or less rather than 50 basis points, for instance) to buy more time to gauge the impact of its decisions.

An outcome on Thursday evening which conformed to the markets’ expectations would make it more likely that the Fed adopted that strategy and would reduce the risk of over-kill.

The more pessimistic would argue that if the Fed isn’t forceful enough in the early part of this year it could lay the foundations for another surge in inflation that would undo much of the heavy lifting it has already undertaken and inflict even more pain on US households and businesses.

The dominance of the US markets within global markets, the significance of the US economy and the US dollar within the global economy and the influence the Fed’s rate-setting has over other central banks and their policies mean its decisions and their outcomes have implications for economies, individuals and businesses well beyond the US borders.

Last year the Fed faced the relatively straightforward task of raising US rates until inflation stopped increasing and the inflation rate started falling back, which it did.

This year the task is far more complicated because the Fed will have to make the trickier judgement of how much of an increase is enough, and when that moment should occur, to ensure the inflation rate will fall into its targeted range over time. The consequences of a misjudgement in either direction would be severe.

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