Fed’s Powell versus inflation versus the markets

On Wednesday afternoon, the Federal Reserve not only raised interest rates for the ninth consecutive time in the face of a banking crisis. It also confirmed that its plans for the year remain more or less intact and that almost all of its leaders expect at least one more rate hike.

• But investors don’t buy it – not even a little bit.

Why it matters: In effect, financial markets are betting that events will overtake the central bank’s best plans and that the banking problems will tighten credit conditions enough to substantially cool growth in the coming months.

Send the news: During Wednesday’s policy meeting, the Fed raised rates by a quarter point and added some optionality to its future plans. The committee noted that the banking situation is likely to weigh on the economy, and that “some” additional policy firming “might” be needed – moving away from earlier language that was more binding.

• In new projections, 17 of 18 Fed policymakers envisaged another rate hike by the end of the year (with the only outlier expected to keep rates stable).

The intrigue: Markets, on the other hand, think that sharp interest rate cuts are almost certain. As of Thursday morning, futures market prices calculated by the CME FedWatch tool implied only about a 2% chance that the Fed’s target rate will be the same or higher by year-end.

• Similarly, government bond markets have shifted in a way that overwhelmingly indicates rate cuts are imminent, even after Powell insisted at his press conference that “rate cuts don’t fit our base case scenario.”
• On Thursday morning, two-year government bonds returned 3.92%, almost a full percentage point below the Fed’s short-term interest rate target.

Between the lines: The Fed chose to continue tightening, feeling that the economic implications of the banking problems, while likely negative, are highly uncertain.

• What on the other hand is what is certain is that inflation is too high and the labor market remains very tight – implying that the Fed must do more to reduce inflation.

• In effect, Powell’s message was that the Fed would switch to easier money only if there was undeniable evidence of a slowdown that would help inflation fall. Mere risk that banking turmoil could lead to that is not enough to change course.
• But the markets are implicitly betting that this is exactly what will happen – that tensions between banks will cause them to withdraw their credit, triggering a recession that in turn crushes inflation.

Part of the dive in bond yields that took place during Powell’s press conference Wednesday was not about what he said. Treasury Secretary Janet Yellen testified on Capitol Hill at the same time, throwing cold water at the idea of ​​indefinite guarantees for all bank deposits.

• But that juxtaposition further proves the point.

It comes down to: Right now, the Fed’s announced plans for monetary policy and the market’s concerns about banks are incompatible — and the entire economic outlook hinges on which is right.