Investors are at odds with Fed officials over the reversal of US interest rates

Investors and Federal Reserve officials disagree about the path of US interest rates this year, widening the gap between policymakers’ expectations and those of the market.

Markets are indicating that the central bank will step back and reverse its months-long campaign to raise interest rates, the most aggressive since the 1980s. Senior Fed officials insist it will hold.

This difference reflects beliefs about future inflation, which has cooled in recent months but is still high by historical standards. “There is a very clear disconnect and disconnect around inflation,” said Priya Misra, head of price strategy at TD Securities.

Most Fed officials supported raising the benchmark federal funds rate above 5 percent and maintaining that level until at least the end of the year in order to cool the economy enough to bring inflation under control.

Futures markets are indicating that the Fed will stop selling, and set its policy rate between 4.75 percent and 5 percent, before implementing interest rate cuts of half a percentage point from peak levels by December. By the end of 2024, the federal funds rate will drop to 2.8 percent, according to market rates, almost a full percentage point lower than what Fed officials projected in December.

Bets on lower interest rates multiplied as investors lowered their inflation expectations. On Friday, the one-year U.S. inflation swap, a derivative contract that reflects inflation expectations for a year from now, hit 1.77 percent, its lowest in more than two years, according to Refinitiv.

Another market measure, called the one-year break-even inflation rate, currently stands at 2 percent.

Ajay Rajadyaksha, global head of research at Barclays, said: “The market really believes that inflation will fall more quickly than the Fed expects. The Fed believes it is very difficult for inflation to come down without weakening the labor market, but the market is not convinced.” “.

Fed officials have sought to dampen speculation that they will soon change course although some favor slowing the rate of increase to a quarter of a percentage point at their next meeting, which ends Feb. 1.

Last week, senior policymakers — including Lyle Brainard, vice chair of the Federal Reserve and John Williams of the New York Fed — reiterated that the central bank will “stay the course” on raising interest rates.

The Fed’s preferred measure of inflation — the core personal consumption expenditures price index — stands at 4.5 percent, down from its peak of 5.4 percent last year, but more than double the central bank’s target of 2 percent.

Central bankers are mainly concerned with inflation in the services sector, which they fear will take longer to clear than price pressures linked to the commodity shock unleashed by the war in Ukraine and supply chain disruptions linked to the Covid-19 pandemic.

“We don’t want to be fake,” Fed Governor Christopher Waller said on Friday. He later said: “Inflation will not miraculously vanish. The process of bringing inflation down will be slower and more difficult, and so we have to keep rates higher for longer and not start cutting prices by the end of the year.”

Market expectations do not equate to consensus on Wall Street. “I don’t think there will be a rate cut in 2023,” said Ron O’Hanley, CEO of State Street Bank, the US custodial bank. “There will be a moderate pace of price increase.”

However, many investors have been paying attention to recent data showing slowing economic activity and other signs that US consumer spending is starting to take a hit.

“The market is cutting rates as there is a lot of conviction that data is going to be weak,” said Kavi Gupta, co-head of interest rate trading at Bank of America.

The latest US employment data, which showed a slowdown in wage growth, has also added to the market’s conviction that inflation will drop significantly.

Erik Winograd, economist at Alliance Bernstein, said the jobs and wages data is “the last piece you need to see to be convinced that the decline in inflation is sustainable.”

However, Winograd said, “There is a lot of hope inherent in the market’s expectations of a rapid decline in inflation.”

Additional reporting by Brook Masters in New York

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