The Fed Appears More Optimistic Than Some Investors. Here’s Why.

At Wednesday’s Federal Reserve meeting, along with warnings of impending pain, policymakers outlined a hopeful scenario in which they could bring inflation down a notch. gently, while the economy, although weakened, is still resilient.

Not everyone in the market agrees.

In particular, traders and analysts who closely follow the trend of interest rates say they are bracing for a more dire outcome than expected by the Fed.

“The market thinks the Fed’s economic projections are an unrealistic illusion,” said Mark Cabana, head of US rate strategy at Bank of America.

Rates traders have been hurt this year as the Fed’s inflation and interest rate outlooks have been repeatedly adjusted by reality. The central bank this week raised interest rates by three-quarters of a percentage point – the third increase since June. The Fed’s policy rate is now the highest since 2008, much higher than forecast earlier this year. And policymakers expect it to rise even higher as the central bank escalates its campaign to reduce high inflation.

After the Fed announced its decision, traders reacted quickly, adjusting prices across a range of interest rate markets such as government bonds and futures to reflect the new path higher. But that’s where the market’s alignment with the central bank ends.

Instead, market prices are reflecting what many analysts expect to happen. Although the Fed does not forecast a rate cut until 2024 at the earliest, analysts are betting that the central bank will have to do so next year. It is widely believed that a drastic rate hike by the Fed will push the US economy into a recession, slowing economic growth and dragging down inflation faster than the central bank predicts. That is likely to force the Fed to shift its focus from fighting inflation and begin cutting rates later next year to support the ailing economy.

“The market thinks the economy will slow down faster than the Fed,” Mr. Cabana said. “The market thinks that will slow inflation faster than the Fed does. And the market thinks that will cause the Fed to shift its focus from addressing inflation to stimulating growth.”

According to EPFR Global, a data provider, stocks fell sharply on Friday, for a second straight week of losses, as investors withdrew $4 billion from a fund that bought U.S. stocks in the seven-day period ending. ends on Wednesday, according to EPFR Global, a data provider.

Higher interest rates increase costs for companies and consumers, often weighing on stock prices. And the Fed isn’t the only central bank raising rates this week, with Policymakers across Europe and Asia all moves in parallel.

“We are likely to be in a worse economic situation than the Fed currently expects,” said Kate Moore, chief executive officer at BlackRock.

In particular, analysts say that the Fed’s expectation of a boost in economic growth next year, which rises to 1.2% from a forecast of 0.2% for 2022, is inconsistent with the level. significantly higher interest rates. Analysts at Barclays note that growth forecasts are “difficult to reconcile” with slowing spending and “growing drag from tightening financial conditions.” As higher rates increase costs for companies, spending falls, hiring slows, and unemployment rises.

The Fed hopes that it can simply stifle job opening without significantly increasing unemployment. However, some analysts doubt that the unemployment rate will be able to remain at the low level expected by the Fed of 4.4% by the end of next year. TD Bank forecasts an unemployment rate of 4.8% by the end of next year. Bank of America expects 5.6%.

Their worse economic outlook means analysts expect inflation to fall more quickly, with the recession cutting consumer and business demand faster rather than a milder slowdown. That also paves the way for the Fed to cut rates to support the economy, something it has said it will only do when it believes inflation returns to its two percent target.

Futures prices now forecast a rate of around 4.3% by the end of 2023, down from a peak of around 4.6% earlier in the year and implying a quarter point drop in the second half of the year.

However, not everyone agrees with what the market is pricing in. Lauren Goodwin, an economist at New York Life Investments, said that she also expects inflation to remain too far from the Fed’s long-held target of 2% for the central bank to consider cutting rates. Instead, Ms. Goodwin said, the market’s hopes for a lower rate are “optimistic and I think too optimistic”.

Part of the challenge for the Fed is accurately forecasting how a rate hike will impact the economy with so many other global forces at work. Besides actions by other central banks, Russia’s ongoing war with Ukraine continues to have an impact on food and energy prices, even as supply chain constraints fuel inflation in the region. The pandemic persists and several emerging economies are on the brink of crisis. .

Members of the Fed committee that sets monetary policy have acknowledged such uncertainty. In their forecasts, they were asked to “state your judgment about the uncertainty associated with your projections relative to the level of uncertainty over the past 20 years” to anonymous responses. must be binary option between higher or lower. All participants, across all forecasts – GDP, inflation and unemployment – answered “higher”, the first since March 2020 and the onset of the coronavirus crisis .

“We don’t know – no one knows – whether this process will lead to a recession or if so, how severe that recession will be,” said Jerome H. Powell, Fed Chairman, on Wednesday. .

For Mr. Cabana, such a high level of uncertainty, coupled with such rapid rate hikes designed to strangle the economy, is worrying.

“We just think the Fed has reflected that they are at the maximum level of uncertainty about how the economy is going to develop,” he said. “If you’re driving a car at 75 mph and aren’t sure where the road is going, the chance of an accident is very high.”

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