Mar 23, 2023 - Economy

Fed's Powell vs. inflation vs. the markets

Fed Chair Jerome Powell

Fed chair Jerome Powell at yesterday's news conference. Photo: Alex Wong/Getty Images

On Wednesday afternoon, the Federal Reserve didn't just raise interest rates for the ninth straight time in the face of a banking crisis. It also affirmed that its plans for the year remain more or less intact, and that nearly all of its leaders expect at least one more rate increase to come.

  • But investors are not buying it — not even a little bit.

Why it matters: Financial markets are essentially betting that events will overtake the central bank's best-laid plans, and that the banking troubles will tighten credit conditions enough to substantially cool growth over the coming months.

Driving the news: At Wednesday's policy meeting, the Fed raised rates a quarter-point while adding some optionality to its future plans. The committee noted the banking situation will likely weigh on the economy, and that "some" additional policy firming "may" be necessary — backing away from earlier language that was more committal.

  • In new projections, 17 of 18 Fed policymakers envisioned raising rates again by the end of the year (with the lone outlier expected to hold rates steady).

The intrigue: Markets, on the other hand, think significant rate cuts are a near-certainty. Thursday morning, futures market prices calculated by the CME FedWatch tool implied only about a 2% chance the Fed's target rate will be the same or higher at the end of the year.

  • Similarly, Treasury bond markets have swung 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 news 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 elected to keep tightening, out of a sense that the economic implications of the banking troubles, while probably negative, are highly uncertain.

  • By contrast, what is certain is that inflation is too high and the labor market remains very tight — implying the Fed needs to do more to bring down inflation.
  • In effect, Powell's message was that the Fed would only pivot toward easier money if there was unmistakable evidence of a slowdown that will pull inflation down with it. The mere risk that bank turmoil could trigger that isn't enough to change course.
  • But markets are, implicitly, betting that is exactly what will happen — that strains among banks will cause them to pull back on credit, causing a recession that, in turn, crushes inflation.

Part of the plunge in bond yields that occurred during Powell's news conference Wednesday wasn't about anything he said. Treasury Secretary Janet Yellen was testifying on Capitol Hill simultaneously and threw cold water on the idea of open-ended guarantees of all bank deposits.

  • But that juxtaposition proves the point further.

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

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