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The Fed appears more optimistic than some investors. Here’s why.

At Wednesday’s Federal Reserve meeting, alongside warnings of impending pain, policymakers outlined a hopeful scenario in which they would be able to gently ease inflation while the economy, albeit flagging, remains resilient.

Not everyone on the market agrees.

In particular, traders and analysts who closely follow the direction of interest rates said they were bracing for a worse outcome than the Fed had forecast.

“The market thinks the Fed’s economic forecasts are an unrealistic fantasy,” said Mark Cabana, head of U.S. interest rate strategy at Bank of America.

Rate traders have been hurt this year as the Fed’s outlook for inflation and interest rates has repeatedly been turned on its head by reality. The central bank hiked interest rates by three-quarters of a percentage point this week – the third such hike since June. The Fed’s interest rate is now the highest since 2008 and well above forecasts at the beginning of the year. And policymakers are predicting it will surge even higher as the central bank escalates its campaign to bring down stubbornly high inflation.

After the Fed announced its decision, traders reacted quickly, adjusting prices on a number of interest rate markets such as Treasuries and futures to reflect the new higher path. But here ended the alignment of the market with the central bank.

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Instead, market prices reflect what many analysts expect. Although the Fed is not forecasting rate cuts until 2024 at the earliest, analysts are betting the central bank will have to do so in the next year. The Fed’s aggressive rate hikes are expected to plunge the US economy into recession, slowing economic growth and dragging down inflation faster than the central bank predicts. That, in turn, should force the Fed to shift its focus from fighting inflation and begin cutting interest rates by the end of next year to prop up the struggling economy.

“The market is assuming the economy will slow faster than the Fed,” Cabana said. “The market believes this will slow inflation faster than the Fed. And the market believes this will cause the Fed to shift from fighting inflation to stimulating growth.”

Shares tumbled on Friday, posting a second straight week of losses as investors withdrew $4 billion from funds buying U.S. stocks over a seven-day period through Wednesday, according to EPFR Global, a data provider.

Higher interest rates increase costs for businesses and consumers and usually weigh on stock prices. And the Fed wasn’t the only central bank to hike rates this week, with policymakers across Europe and Asia acting in concert.

“We are likely to end up in a worse economic situation than the Fed is currently forecasting,” said Kate Moore, managing director at BlackRock.

Notably, analysts said the Fed’s expectation of accelerating economic growth next year, rising to 1.2 percent from a forecast 0.2 percent for 2022, is inconsistent with such sharply higher interest rates. Barclays analysts said the growth forecast was “difficult to reconcile” with falling spending and the “mounting strain of tightening financial conditions”. As higher interest rates raise costs for businesses, spending falls, hiring falls and unemployment rises.

The Fed hopes it can just cut job vacancies without significantly increasing unemployment. However, some analysts doubt the unemployment rate can remain as low as the 4.4 percent forecast by the Fed by the end of next year. TD Bank forecasts an unemployment rate of 4.8 percent by the end of next year. Bank of America expects 5.6 percent.

Their worsening economic outlook means analysts expect inflation to come down faster, with a recession cutting consumer and business demand faster than a milder slowdown. It also paves the way for the Fed to cut interest rates to support the economy, something it has said it will only do if it is confident that inflation will return to its 2 percent target heading for

Futures prices are currently forecasting a rate of around 4.5 percent through the end of 2023, compared to a peak of around 4.7 percent earlier in the year, implying a single quarter-point decline in the second half of the year.

But not everyone agrees with what the market is pricing in. Goldman Sachs forecasts are closely aligned with those of the Fed, and bank analysts expect interest rates to remain high throughout next year, with inflation proving difficult to contain. Lauren Goodwin, an economist at New York Life Investments, said she also expects inflation to remain too far from the Fed’s long-term target of 2 percent for the central bank to consider a rate cut. Instead, Ms Goodwin said, it is the market’s hope for lower rates that is “optimistic and, in my opinion, overly optimistic”.

Part of the Fed’s challenge is accurately predicting how rate hikes will affect the economy when so many other global forces are at play. In addition to actions by other central banks, Russia’s war with Ukraine continues to affect food and energy prices, even as the supply chain constraints that have fueled inflation during the pandemic remain in place and some emerging markets stand on the brink of crisis.

Members of the Fed’s committee that sets monetary policy have acknowledged this uncertainty. In their forecasts, they are asked to “state their assessment of the uncertainty associated with their forecasts in relation to the level of uncertainty over the past 20 years”, with anonymous answers having to be a binary choice between higher or lower. All participants, across all forecasts – gross domestic product, inflation and unemployment – answered “higher”, the first time since March 2020 and the start of the coronavirus crisis.

“We don’t know – nobody knows – whether this process will lead to a recession or, if so, how significant that recession would be,” Jerome H. Powell, Fed Chairman, said on Wednesday.

For Mr. Cabana, such a high level of uncertainty alongside such rapid rate hikes aimed at choking the economy is unsettling.

“We just think the Fed has reflected that they have maximum uncertainty about how the economy is going to perform,” he said. “If you’re driving a car at 75 miles an hour and you’re not sure where the road is going, then the chances of an accident are pretty high.”

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