Federal Reserve and the markets in standoff on rate hikes

WASHINGTON (AP) — Sooner or later, Wall Street or the Federal Reserve has to blink.

Nearly a year after the Fed’s efforts to suppress inflation by sharply raising interest rates, investors still don’t seem to fully believe what the Fed is warning: higher rates by the end of the year, which could sharply raise unemployment and slow growth.

Wall Street has a clearer view: Inflation is cooling from painful highs, investors are betting that the Fed will stop raising rates soon, pause for a moment and then start cutting rates later in the year to counter what many on Wall Street expect will be a mild recession. That relatively upbeat outlook has helped the broad S&P 500 gain 4.4% so far this year.

However, many Fed speakers last week emphasized a mixed message: They expect to raise their benchmark rate above 5%, slightly above Wall Street’s forecast. That would likely lead to even higher borrowing rates for consumers and businesses, from mortgages to auto loans and business loans. In addition, some Fed officials reiterated that they plan to hold rates higher by the end of this year.

The gap between the Fed’s forecasts and Wall Street’s expectations could have far-reaching consequences for both American finances and the economy.

For investors, rate cuts are almost like steroids. They make it cheaper to borrow, and they usually set prices for everything from stocks to bonds to cryptocurrencies. That’s why investors are so eager to anticipate when the next rate cut might come, hoping to anticipate it and reap the most from rising stock and other asset prices.

On the other hand, if the Fed follows through on its warnings of still higher rates, the economy could not only fall into recession, but endure a deeper and longer recession than it would have if it had followed the path of the market.

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Wall Street investors have encouraged the widely held assumption among economists that the Fed will raise its key rate next week by a smaller step, just a quarter. That would mark a downgrade from the Fed’s December rate hike of half a point and four consecutive three-quarter point hikes before that.

Fed officials have forecast that their key short-term rate, currently in a range of 4.25% to 4.5%, will eventually reach 5% to 5.25%. In contrast, futures markets suggest that most investors expect the rate to peak between 4.75% and 5% – if not lower.

“The market’s view on this is obviously that the more you cut, the closer you’re probably going to be to completing a rate hike,” said Michael Geppen, chief U.S. economist at Bank of America. “The more you spread out the hikes, the less likely you are to get some of them,” he added, because the economy could go into recession and discourage further hikes before the Fed can implement them.

Wall Street investors appear confident that the Fed has largely tamped down inflation, which would make further rate hikes unnecessary. According to Deutsche Bank, investors think that with some measures, inflation could fall to almost 2% by the end of this year, from 6.5% currently. Fed policymakers, on the other hand, have jointly forecast that inflation will still be 3.1% at the end of the year.

“There’s a very optimistic view in the market that inflation is just going to melt away,” Fed Board Member Christopher Waller said last week. “We have a different view. It will be slower and more difficult to reduce inflation. And so we need to keep rates higher longer and not start cutting rates until the end of the year.

Waller and other Fed officials point to a strong labor market as a factor that may keep inflation high. The unemployment rate, currently at 3.5%, has not been lower in half a century. Businesses continue to raise wages to retain and attract workers, which generally increases consumer spending. Employers, on the other hand, usually pass on their higher labor costs to their customers in the form of price increases. The Fed fears that both trends will keep inflation well above its 2% target.

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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 will be under pressure to start cutting rates to try to stimulate the economy.

“Markets are very used to easing their policy at the first sign of trouble,” said Gennady Goldberg, senior interest rate strategist at TD Securities.

But this time, the Fed “needs to see pain to reduce inflation,” Goldberg said. Fed officials predict that the unemployment rate could reach as high as 4.6% by the end of this year, which would mean that about 1.5 million people would lose their jobs. As a result, Goldberg said, “they can hardly facilitate their political goals right now.”

“It’s going to be a very interesting break once the economy starts to soften,” he said. “I think you’re going to have some investors who are going to be very disappointed.”

Oxford Economics market analyst John Canavan said the 10-year Treasury yield could rise from its current level of around 3.5% to 3.7% if the Fed raises rates above market expectations. Mortgage rates will rise, at least in the short term.

In several speeches last week, several Fed officials expressed optimism that inflation is coming down even faster than they had expected. After peaking at 9.1% in June, 12-month inflation rates have fallen for six consecutive months to 6.5%.

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However, those officials, including Chairman Jerome Powell, have stressed the need to avoid stopping rate hikes prematurely for fear that inflation will pick up again and then demand even tougher policy measures. They want to avoid the mistakes of the 1970s, when the Fed raised rates only to cut them once unemployment rose, but before high inflation was cut decisively.

Any Fed tapering could trigger a big rally on Wall Street, with stock prices soaring and bond yields falling. This option, which would be desirable for investors and businesses, is something the Fed would like to avoid: it could encourage excessive spending and possibly reignite inflation.

Federal Reserve Bank of Dallas President Lori Logan said if investors get too excited about falling inflation and markets rise, the Fed may have to raise rates even higher than it has forecast.

But the central bank’s determination to keep rates high coincides with recent evidence that the economy is slowing, renewing fears that a recession could soon begin. Consumers have reduced their spending at retailers for two months in a row. Factory output fell sharply in November and December. Home sales have fallen for 11 straight months, and were at their lowest level last year in almost ten years.

However, a recession could prove the markets right because a recession, especially a deep one, could lower inflation much faster than the Fed expects. And while Fed policymakers have said they plan to continue raising rates, they have also said they could end hikes if the economy reverses.

“If we get inflation coming down faster than I’m projecting, then I may have to adjust my current policy,” Cleveland Federal Reserve President Loretta Mester told The Associated Press last week.

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Cho reported from New York.

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