Fed’s Powell vs. inflation vs. the markets

Fed Chairman Jerome Powell at yesterday’s press conference. Photo: Alex Wong/Getty Images

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

But investors aren’t buying it — not one bit.

Why it matters: Financial markets are essentially betting that events will overtake the central bank’s best-laid plans and that banking woes will tighten credit conditions enough to significantly dampen growth over the coming months.

Headline: At Wednesday’s policy meeting, the Fed raised rates by a quarter point while adding some options to its forward plans. The committee noted that the banking situation is likely to weigh on the economy and that “some” additional policy tightening “may be” necessary – moving away from earlier language that was more committed.

In the new forecasts, 17 of the Fed’s 18 policymakers expected to raise rates again by the end of the year (with the only one expected to keep rates steady).

Intrigue: Markets, on the other hand, think a significant rate cut is almost certain. On 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 the end of the year.

Similarly, Treasury bond markets have fluctuated in ways that overwhelmingly indicate rate cuts are on the way, even after Powell insisted “rate cuts are not in our base case” at his press conference. On Thursday morning, two-year Treasuries were yielding 3.92%, nearly a full percentage point below the Fed’s target for short-term rates.

Between the lines: The Fed chose to continue tightening, out of a sense that the economic implications of banking problems, while possibly negative, are too uncertain.

In contrast, what is certain is that inflation is very high and the labor market remains very tight – meaning the Fed needs to do more to reduce inflation. In fact, Powell’s message was that the Fed would only move toward easier money if there was unmistakable evidence of a slowdown that would bring inflation down with it. The mere risk that banking turmoil might cause 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 pull back on lending, triggering a recession that, in turn, suppresses inflation.

Part of the fall in bond yields that occurred during Powell’s press conference on Wednesday was not because of anything he said. Treasury Secretary Janet Yellen was simultaneously testifying on Capitol Hill and threw cold water on the idea of ​​indefinite guarantees of all bank deposits.

But this juxtaposition further proves the point.

The bottom line: Right now, the Fed’s stated plans for monetary policy and the level of market concern about banks are incompatible — and the entire economic outlook hinges on which is right.