Surprisingly strong recent readings for U.S. employment and inflation have been notable for causing markets to rethink the path of U.S. Federal Reserve policy in some ways but not others.
Following the latest economic data, the Fed’s terminal policy rate implied by short-dated interest rate forwards increased to about 5.3%, a level expected to be reached in the second quarter of 2023. But markets haven’t much changed the expected path of Fed rate cuts thereafter, still implying a reduction from that peak to roughly 3.65% by the end of 2024.
We think there is a reasonable narrative to support this expectation. Fed policy is currently restrictive and, over the next several months, will likely become even more so. But precisely because policy is restrictive, the threshold to normalize policy thereafter – returning it to levels that are neither restrictive nor expansionary – should not be all that high. Indeed, all it should take is for inflation to moderate. The disinflationary cycle, which is likely to accelerate in the second half of this year, will result in ex ante real short-term borrowing costs that are high by historical standards.
Markets and policymakers seem overly focused on the terms “easing” and “tightening.” Instead, we would suggest “normalizing.” This is more than semantics: Normalizing is different from returning to easy policy, as the required actions to maintain a level of restriction or neutrality are very different than actions to stimulate aggregate demand. We continue to think the bar to outright policy easing remains high. It’s likely to take a more pronounced recession.
Surprise and revise
Following the latest Federal Open Market Committee (FOMC) meeting on 1 February, Fed Chair Jerome Powell said the divergence between the path of the federal funds rate as implied by forward rate contracts and Fed officials’ latest Summary of Economic Projections from December was likely the result of “the market’s expectation that inflation will move down more quickly.”
And, indeed, after subsequent Labor Department data for January showed U.S. jobs growth had surged while U.S. inflation had surprisingly accelerated, the bond market priced in a greater chance of a higher fed funds rate. The yield on the fed funds futures contract expiring in June 2023 rose to about 5.3%, roughly in line with the median path projected by Fed officials.
Nevertheless, the market curve remains inverted, with yields on longer-dated fed funds futures trading below those of shorter-maturity contracts. That shows markets still assign a relatively high probability to Fed cuts in 2024 and beyond.
The FOMC’s projections released last December show a median expectation of a fed funds rate between 4% and 4.25% in 2024, indicating that the Fed itself agrees with the direction of normalization. That said, the range of expectations from FOMC members is 3.125% to 5.625%, highlighting the level of uncertainty.
The options market expects the Fed may cut rates even more than officials project. According to the Secured Overnight Financing Rate (SOFR) options market, which is more liquid than the fed funds market, the implied probability that the policy rate would be below the FOMC’s 4.1% median in 2024 was close to 50%, at the time of this writing – only down marginally from the roughly 60% probability implied at the time of the 1 February FOMC meeting. (For more, see our blog post, “Disappointing Details in January CPI Report May Give the Fed Room to Maneuver.”)
Why then has the market’s pricing of the Fed rate path, and the probability of cuts in particular, been so persistent? We see one more main reason.
Given monetary policy appears increasingly restrictive, the current fed funds rate level is likely not sustainable for the medium term, and eventually the impact of higher rates will slow aggregate demand and cool inflation. In our view, it’s not a matter of if this will happen but when, and at what rate level.
Historically, the lag through which monetary policy impacts the economy was thought to be 12 to 24 months. To be sure, the lag this time could be affected by unique factors including the pandemic, a potential near-term reacceleration in global activity after Europe narrowly avoided recession over the winter, and China’s relaxed COVID-19 restrictions. But applying this rule of thumb, we should expect to see clearer evidence of weaker demand by midyear – consequentially when the yields on futures contracts also peak.
The lagged economic effects of higher rates and restrictive policy also likely explain why, historically, the Fed hasn’t stayed at a peak terminal rate level very long. Data since the 1980s suggest the Fed has held steady after a hiking cycle for around seven months on average, and for less time during inflationary cycles. Furthermore, when the Fed did start cutting, it did so by an average of 230 basis points in the year after the cuts started.
Normal isn’t easy
Given this backdrop, it is not surprising that market participants see an elevated probability that the Fed’s terminal pause is similarly short-lived and that rate cuts will soon follow. For the Fed to normalize policy, all we would likely need is for inflation to come down – not a recession.
Again, however, normalizing is different from easing. And there is one other key implication of this nuance: The Fed may not alter its current quantitative tightening (QT) program when it does begin to normalize, as rate cuts wouldn’t conflict with the policy stance behind reducing the stockpile of bonds on the Fed’s balance sheet.
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