The market believes that interest rates will fall a lot. It can let you down

Markets appear to have taken this week’s positive economic data as a clear signal for the Federal Reserve to begin cutting interest rates aggressively next year.

Indications that consumer and headline inflation rates will decline significantly from their peak in mid-2022 have sent traders into a frenzy, with the latest indicators emerging… FedWatch from CME Group The measure indicates a full percentage point of cuts by the end of 2024.

That may be at least somewhat optimistic, especially given the cautious approach taken by central bank officials during their rate-cutting campaign.

“The issue has not yet been resolved,” said Lou Crandall, chief economist at Wrightson ICAP. “We are making progress in that direction, but we have not reached the point where they will say the risk of settling much higher than the target has passed.”

This week included two important Labor Department reports, one showing that overall consumer prices were unchanged in October, while another noted that wholesale prices actually fell by half a percent last month.

While the 12-month PPI reading fell to 1.3%, the CPI remained at 3.2%. Core CPI is also still running at a 12-month average of 4%. Moreover, the The Atlanta Fed’s measure of “sticky” prices. Which do not change as often as the prices of items such as gas, groceries and car prices, showed that inflation is still rising at an annual rate of 4.9%.

“We’re getting close,” Crandall said. “The data we got this week is consistent with what you want to see as you move in that direction. But we’re not there yet.”

The Fed’s “destination” is a place where inflation does not necessarily reach its 2% annual target but shows “convincing” progress that it is getting there.

“What we decided to do is hold the interest rate and wait for more data,” Fed Chairman Jerome Powell said in his post-meeting press conference in September. “We want to see convincing evidence, really, that we have reached the appropriate level.”

While Fed officials did not indicate how many consecutive months it would take for inflation data to ease to reach that conclusion, the core 12-month CPI has fallen every month since April. The Fed favors core inflation measures as a better measure of long-term inflation trends.

Traders appear to have more certainty than Fed officials at this point.

Futures pricing on Wednesday indicated there was no chance of additional increases this cycle. The first-quarter percentage point cut would come in May, followed by another in July, and likely another two percentage points before the end of 2024, according to a CME Group pricing gauge in Federal funds futures market.

If true, that would bring the benchmark interest rate down to a target range of 4.25% to 4.5% and would be twice as strong as the pace Fed officials expected in September.

Hence, markets will be keenly watching how officials will react at the next policy meeting in December. 12-13. In addition to the interest rate call, the meeting will see officials make quarterly updates to interest rate forecasts, as well as forecasts for GDP, unemployment and inflation.

But pricing in the Fed’s actions can be volatile, and there are two more inflation reports ahead of that meeting. Wall Street may find itself disappointed in the way the Fed views its near-term policy path.

“They’re not going to want to signal that it’s time to start talking about rate cuts, even if federal funds futures… It has already been integrated.

The market’s enthusiasm this week was built on two main supports: the belief that the Fed may start cutting interest rates soon, and the idea that the central bank can deliver its vaunted “soft landing” for the economy.

However, it is difficult to reconcile the two points, considering that such aggressive easing of monetary policy has historically only accompanied recessions in the economy. Fed officials also appear reticent to take too pessimistic a stance, with Chicago Fed President Austan Goolsbee saying on Tuesday that he sees “a way to go” before the inflation target is reached even as a potential “golden path” is opened to avoid a recession. .

“The more likely outcome is a slowdown in the economy rather than a recession,” Rosengren said. “But I would say there are definitely downside risks.”

The stock market rally combined with the recent decline in Treasury yields poses another challenge for the Fed as it looks to tighten financial conditions.

“Financial conditions have softened significantly as markets anticipate the end of Fed rate hikes, and that may not be an ideal basis for the Fed to claim to keep rates high for longer,” said Quincy Crosby, chief global strategist at LPL Financial.

Indeed, the “Higher for Longer” mantra has been a cornerstone of the Fed’s recent communications, even from those members who have said they are against additional rate hikes.

It’s part of a broader sense at the central bank that it doesn’t want to repeat past mistakes by stopping fighting inflation once the economy shows any signs of faltering, as it has done recently. For example, consumer spending fell in October for the first time since March.

For Fed officials, this adds up to a difficult calculation as officials are loathe to express overconfidence that the last mile is in sight.

“Part of the problem the Fed always has to deal with is the illusion of control,” said Crandall, an economist who started at Wrightson ICAP in 1982. “They can influence things, but they can’t control them.” There are also many external factors fueling the dynamics. complexities of the modern global economy. So I’m somewhat optimistic [the Fed can achieve its inflation goals]. “This is a little different than being confident.”