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Prior to the Jackson Hole meeting, the market is pricing policy rates to peak at about 3.8% in the spring of 2023. Powell stated that without price stability, the economy does not work. He expects to hike into a recession (‘likely to require a sustained period of below-trend growth’) translating into higher unemployment (‘likely be some softening of labor market conditions’) impacting the economy (‘some pain to households and businesses’). After the meeting, the market is still pricing policy rates to peak, now at about 3.9%, in the spring of 2023 with half a cut less by the end of 2024 (see graphs). Until now, nothing has fundamentally changed. This is illustrated by the attached graph.
The area where the market pricing is fundamentally diverging from the Fed is about the length of time the policy will remain restrictive. Powell talks about ‘maintaining a restrictive policy stance for some time’. The market does not see a ‘plateau’ in policy rates and is immediately pricing several cuts in the second half of 2023 and 2024, though the market now sees half a cut less than expected prior to the speech. Cuts also mean that the balance sheet reduction will have stopped by then.
In September, we will get a new set of ‘Dot plots’, the summary of economic projections. In this document, the views of individual Fed members are summarised in terms of rate expectations, unemployment, inflation, and growth. Although policy rate expectations of the previous Dot plot in June could be considered in line with current market expectations, the Fed members’ rhetoric has been rather consistent about tightening direction, as exemplified by Powell’s speech. This will be clear in the September Dot plots, likely re-enforcing Powell’s speech: the Dot plots will be more hawkish.
The current Fed narrative is clearly not aligned with market pricing. What will happen next?
In a first scenario, assume the Fed stays on message and keeps a more restrictive stance versus what’s currently priced in. Presumably the market will get the message and will price accordingly: by selling off in the short/medium part of the curve, by further inverting, but likely followed by some re-steepening to a flatter curve. The long end of the curve likely provides the best protection for this scenario.
The opposite scenario is more chaotic: in the light of a recession, combined with political pressure, the Fed resumes a less restrictive path, despite elevated inflation. This would lead to a very complex debate about whether unemployment or inflation is a higher priority in the Fed’s mandate. This would probably result in a lot of inconsistent Fed messages as different Fed members, and other economists, disagree. Many outcomes are possible in this scenario, but rate volatility will be very elevated. Inflation-linked bonds will likely be helpful under this scenario.
Whether the first or second scenario materialised will depend on the depth of a slow-down and the persistence of high inflation. The market clearly prices in a worse slow-down and less persistent inflation compared to the Federal Reserve. The one factor which is not yet considered in this context is inflation volatility. As one expects inflation to normalise from the current 8.5% to target (or somewhat above target), it is important to consider that such normalisation will not be smooth. As part of the inflation basket will be exposed to significant basis effects, we could temporarily see very low or even negative prints for very short periods, followed by rebounds to higher inflation. The path to ‘normalisation’ will be erratic. This will further convolute the decision-making process. Despite the seemingly clear path laid out by Powell, the outlook seems a lot more uncertain.