Are the markets underestimating how far the Fed needs to go to tame inflation?

The Federal Reserve is less than four months into its latest rate hike cycle, and yet investors are already pricing in rate cuts starting next year, the latest sign that the market is bracing — or perhaps rather hoping — for a quick return to the accommodative monetary policy that was the driving force behind the booming stock market of the years following the 2008 financial crisis.

Deutsche Bank economist Jim Reid pointed out in his latest Chart of the Day note that the Fed is financing futures market, a derivatives market that allows investors to bet on the direction of the Fed’s interest rate policy . , is already anticipating a backlash towards accommodative monetary policy sometime next year. After the Fed Funds rate hits its current market-expected peak of 3.39% in February 2023, investors expect the central bank to cut rates again, which would amount to a “victory” over inflation.

But will such a short period of tighter policies be enough to beat inflation? As Reid points out, if the expectations turned out to be correct, it would pose an interesting problem for the Fed: It would be the first time in 70 years that the Fed’s rate target level would not surpass the inflation rate throughout the year. a rate walking cycle.

At the moment, markets expect that Fed Funds rates in “real” terms – that is, adjusted for inflation – will not reach positive territory at any point during this tightening cycle.

Fed Chair Jerome Powell has repeatedly acknowledged that many of the factors contributing to high inflation are beyond the Fed’s control. The Fed cannot magically lower commodity prices, nor resolve the war in Ukraine, or any lingering supply chain problems caused by Beijing’s response to the latest COVID outbreak.

In fact, the whole purpose of raising interest rates is to hopefully choke the economy and weaken the U.S. labor market, leading to higher unemployment and a decline in demand.

It is also noteworthy that investors expect the tightening cycle to be over in about a year. The Fed raised interest rates in March for the first time since late 2019.

How unusual would such a short tightening cycle be? Looking at the last few cycles of rate hikes, there were a few that were shorter than 2 years: one cycle lasted from February 1994 to July 1995. Another lasted from June 1999 to January 2001. Others were longer. The cycle of rate hikes that preceded the Great Financial Crisis in 2008 began in June 2004 and ended in September 2007. By comparison, the cycle that began in December 2015 and ended in August 2019 lasted nearly four years, although the Fed chose a much more more gentle pace during this cycle.

Source: Deutsche Bank

But it certainly seems remarkable that the markets are not anticipating positive real interest rates as the Fed tries to tackle its most aggressive inflation since the early 1980s.

Which leads Deutsche Reid to ask the markets a critical question: are investors too optimistic? After all, if expectations start to shift in favor of a more aggressive pace of Fed tightening, that could lead to more pain in both bonds and stocks.

Concerns about slowing US economic growth weighed on stocks on Tuesday, with the Dow Jones Industrial Average DJIA,
-0.42%
dropped more than 600 points. The S&P 500 SPX,
+0.16%
decreased by 1.9% to 3,754. Meanwhile, the 10-year Treasury yield is TMUBMUSD10Y,
2,820%
had fallen by more than 9 basis points to 2.793%.

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