WASHINGTON– Sooner or later, either Wall Street or the Federal Reserve will have to blink.
Nearly a year after the Fed’s rush to quell inflation with rapid rate hikes, investors still don’t seem to quite believe what the Fed is warning next: Higher rates through the end of the year that could send unemployment sharply and slow Growth.
Wall Street is more optimistic: As inflation cools off painful highs, investors are betting that the Fed will soon stop raising rates, pause for a while, and then start cutting rates later in the year to counter the expectations of many on Wall Street will be a mild recession. That relatively optimistic view has helped the broad S&P 500 stock index rise 4.4% so far this year.
But a host of Fed speakers last week underscored a conflicting message: they expect to raise interest rates to over 5%, slightly ahead of Wall Street’s forecast. This would likely lead to even higher borrowing rates for consumers and businesses, from mortgages to car loans to business loans. In addition, some Fed officials reiterated that they plan to raise interest rates by the end of this year.
The discrepancy between the Fed’s forecast and Wall Street’s expectations could have far-reaching implications for American finances and the economy.
For investors, rate cuts are almost like steroids. They make borrowing cheaper and typically raise the prices of everything from stocks to bonds to cryptocurrencies. This is why investors are so eager to find out when the next rate cut might happen, hoping to get in before it and reap the most benefit from the resulting rise in the prices of stocks and other assets.
On the other hand, if the Fed carries out its warnings of even higher interest rates, the economy could not only slide into recession, but suffer a deeper and longer recession than it would have had had it followed the market path instead.
Investors on Wall Street have been heartened by the widespread assumption among economists that the Fed will hike interest rates by a smaller step, just a quarter point, at next week’s meeting. That would mean a half-point cut in the rate hike the Fed imposed in December and four consecutive three-quarter-point hikes before that.
Fed officials have forecast that their short-term interest rate, which currently ranges from 4.25% to 4.5%, will eventually reach 5% to 5.25%. In contrast, futures markets show that a majority of investors expect the interest rate to be in the range of 4.75% to 5% — if not lower.
“Obviously the way the market is looking at this, the more down you tune, the closer you are likely to the end of rate hikes,” said Michael Gapen, chief US economist at Bank of America. “The more you spread out the rate hikes, the less likely you are to get some of them,” he added, as the economy may slip into recession and discourage further rate hikes before the Fed can implement them.
Wall Street investors appear confident that the Fed has largely lashed out at inflation, which would make additional rate hikes unnecessary. According to Deutsche Bank, investors believe inflation could fall to almost 2% by the end of this year from the current 6.5%. Meanwhile, Fed policymakers are collectively forecasting that inflation will still be 3.1% by the end of the year.
“The market is very optimistic that inflation will just melt away,” Christopher Waller, a member of the Fed’s Board of Governors, said last week. “We have a different opinion. Bringing down inflation will be a slower and more difficult task. And that’s why we need to keep rates high for longer and not start cutting rates until the end of the year.”
Waller and other Fed officials point to the resilient labor market as a factor likely to keep inflation high. The unemployment rate, now 3.5%, has not been lower in half a century. Businesses continue to raise wages to retain and attract workers, which usually translates into higher consumer spending. Employers, in turn, typically pass on their higher labor costs to their customers in the form of price increases. Both trends, the Fed fears, will keep inflation well above its 2% target.
Many traders also say they expect the Fed to blink once unemployment starts rising steadily while inflation falls. With potentially millions of people facing layoffs, the Fed would be under pressure to start cutting rates to try to stimulate the economy.
“Markets have become very accustomed to easing at the first sign of trouble,” said Gennadiy Goldberg, senior interest rates strategist at TD Securities.
But this time, “the Fed needs to see pain to bring inflation down,” Goldberg said. Fed officials are forecasting that the unemployment rate could reach as high as 4.6% by the end of this year, meaning about 1.5 million people would lose their jobs. As a result, Goldberg said, “they are almost unable to let up right now to achieve their policy goals.”
“It’s going to be a very interesting split once the economy actually starts to slow down,” he said. “I think you’re going to have some investors who are going to be bitterly disappointed.”
John Canavan, a market analyst at Oxford Economics, suggested that the yield on the 10-year Treasury note could rise to 3.7% from its current level of around 3.5% if the Fed hikes rates beyond what the market expected. Mortgage rates would rise, at least in the short term.
In a series of speeches over the past week, several Fed officials expressed optimism that inflation is easing even faster than they had expected. After peaking at 9.1% in June, 12-month inflation measures have fallen to 6.5% for six straight months.
Still, these officials, including Chairman Jerome Powell, have stressed the need not to suspend their rate hikes too soon amid fears that inflation will reaccelerate and then require even tougher policy action. They want to avoid the mistakes of the 1970s, when the Fed raised interest rates only to lower them as unemployment rose, but before high inflation was decisively crushed.
Any relaxation of the Fed could trigger a major rally on Wall Street, with stock prices rising and bond yields falling. This opportunity, welcome as it would be for investors and companies, would be something the Fed would want to avoid: it could fuel excessive spending and potentially reignite inflation.
Lorie Logan, President of the Federal Reserve Bank of Dallas, said if investors get too giddy about falling inflation and markets tighten, the Fed may have to hike rates even more than forecast.
But the central bank’s determination to keep interest rates high has coincided with recent signs the economy is slowing, renewed fears that a recession could soon begin. Consumers have cut retail spending for two months. Factory production fell sharply in November and December. Home sales have fallen for 11 straight months, and last year marked the lowest level in nearly a decade.
But a recession could end up proving markets right, because a downturn — especially a deep one — could bring inflation down much faster than the Fed expects. And while Fed policymakers have said they intend to raise rates further, they have also said they may halt hikes if the economy shifts course.
“If inflation comes down faster than I’m predicting, I may have to adjust my current policy stance,” Loretta Mester, Cleveland Federal Reserve Chair, said in an interview with the Associated Press last week.
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Choe reported from New York.
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