The Fed's announcement that interest rates will remain on hold for "some time" clashed with bets to cut rates in 2023.

(Bloomberg) — Federal Reserve Chairman Jerome Powell has history on his side as he and his colleagues split with Wall Street on how long interest rates will stay high in 2023.

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After the fastest monetary tightening since the 1980s, the central bank looked poised to raise its benchmark interest rate by 50 basis points on Wednesday to the downside after four consecutive moves of 75 basis points to curb inflation.

Such a move – widely flagged by officials – would lift interest rates to a target range of 4.25% to 4.5%, the highest level since 2007. They are also likely to signal another 50 basis points of tightening next year , according to economists polled by Bloomberg, and an expectation that once they reach that peak, they will remain on hold throughout 2023.

Financial markets agree with the near-term outlook, but see a quick retreat from peak interest rates later next year. That clash may be because investors expect price pressures to ease faster than the Fed, which worries that inflation will prove sticky after being burned by a bad call that would be transitory. It may also reflect bets that rising unemployment will become a more serious concern for the Fed.

This week’s meeting in Washington is another opportunity for Powell to lay out his position that officials expect to keep interest rates high to beat inflation – as he did in a speech on November 30, when he stressed that policy would remain restrictive “for some time.” .

Over the past five interest rate cycles, the average peak rate hold was 11 months, and these were periods when inflation was more stable.

“The Fed is pushing the message that the key interest rate is likely to remain at its peak rate for some time,” said Conrad De Quadros, senior economic adviser at Brean Capital LLC. “That’s the part of the message that the market has consistently missed. Estimates of the extent to which inflation will fall are too optimistic.

In the tension between communication between the Fed and investors, there are two different views of the post-pandemic economy: Markets’ view shows a confident central bank that is quickly nudging inflation toward its 2% target, possibly with the help of a mild recession or disinflationary forces that have kept prices low for two decades.

Financial markets “are just pricing in a normal business cycle,” said Scott Thiel, chief fixed-income strategist at BlackRock Inc, the world’s largest asset manager.

A competing view says supply constraints will be an inflationary force for months and perhaps years as redrawn supply lines and geopolitics affect critical inputs from chips and labor talent to oil and other commodities.

In this thesis, central banks will be cautious about progress on inflation, which may only be temporary and may be vulnerable to the emergence of new frictions that cause price pressures to continue.

“Strategic competition” is inflationary, Thiel says. “We expect inflation to be more resilient, but we also expect inflation volatility and for that matter the broader economic data to be higher.”

Swaps traders are currently betting that the funds rate will reach just below 5% in the May-June period, with the full quarter-point cut coming around November, and the policy rate ending next year at around 4.5%.

That would mark an unusually quick declaration of victory over inflation, which is now three times the Fed’s 2% target.

“The futures curve is a manifestation of the success or failure of the FOMC’s communication policy,” said John Roberts, the Fed’s former chief macro modeler on the board, who now blogs and consults with investment managers, referring to the Federal Open Market Committee. .

Also not just the timing of the cuts to begin, but also how much money market traders expect it to exceed historical norms. The more than 200 basis points of Fed rate cuts now priced into futures markets are the most ahead of any policy easing cycle since 1989, according to Citigroup Inc.

Futures contracts suggest a rate cut by the Fed will end around mid-2025, according to Bloomberg data.

Fed officials do not completely rule out a rapid slowdown in inflation. John Williams, the New York Fed president, said he expected the rate of inflation to halve next year to around 3% to 3.5%.

Commodity price inflation has begun to cool, and the softening of new rental rates for homes and apartments should ultimately contribute to lower reported shelter costs. Prices for services, minus energy and shelter, a measure highlighted by Powell in a recent speech, slowed in October.

Investors are also optimistic about price pressures. Pricing in Inflation Swaps and Treasury Inflation Protected Securities predicts a sharp decline in consumer prices next year.

But there are also signs that the road back to the Fed’s 2% target could be long and bumpy.

Employers added jobs at a rate of 272,000 per month over the past three months. That’s slower than the 374,000 average over the previous three months, but still solid and one reason demand is holding up.

Historically, Fed officials note, there has been a sticky quality to inflation, meaning it takes a long time to extricate itself from the millions of pricing decisions that businesses and households make every day.

They also measure the achievement of their policy as delivering 2% inflation, not 3%, and may be reluctant to start cutting borrowing costs if inflation remains above their target.

Williams, for example, said he did not expect any cuts in the benchmark lending rate until 2024, although he expected a drop in inflation measures next year.

“People like to focus on things going back to where they were. But the trend” of higher rates “could go on for quite some time,” said Kathryn Kaminsky, chief research strategist and portfolio manager at AlphaSimplex Group. “That’s something people are underestimating.”

–With help from Alex Tanzi and Simon White.

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