The Fed and the market disagree. Someone is wrong

The Federal Open Market Committee raised its policy rate to a range of 4.25 to 4.50 per cent in December and published projections showing a peak of 5.1 per cent in 2023. Futures markets promptly priced a peak below 4.9 per cent and 50 basis points of cuts before the end of the year. That is too wide a gap to be a tactical difference of opinion. It is a standoff between the Fed and the bond market. Either the Fed will drop its stated resolve as the economy slows, or bond markets are nursing a delusion that will end in a violent repricing.

Markets have reasons for their cynicism. In the fifteen years since the financial crisis, central banks have blinked at the first sign of falling share prices or widening credit spreads. The consumer-price figures published a day before the decision, showing inflation down to 7.1 per cent in November, gave traders fresh evidence that the worst had passed.

What the dots actually say

The half-point rise followed four consecutive increases of three-quarters of a point, so the Fed has slowed the pace while raising its destination. The same projections put the median rate at 4.1 per cent by the end of 2024, which means the committee does expect to cut eventually. The quarrel with the market is about timing: the Fed pencils in easing a year from now, while futures price it within months.

Officials also forecast unemployment rising to 4.6 per cent by the end of next year. In other words, the committee already assumes a weaker labour market and still does not plan to cut. That removes the market's most obvious trigger for a pivot, because the Fed has told it in advance that a rise in joblessness of that size would not be enough.

The growth forecast tells the same story. The median official expects the economy to expand by just 0.5 per cent next year, close to stagnation, while core inflation on the Fed's preferred measure is still projected at 3.5 per cent at the end of 2023. A committee that forecasts near-zero growth and above-target inflation in the same year is describing a mild recession it intends to tolerate.

Betting on the Fed put

Bond traders are wagering that rising unemployment and slowing monthly inflation will push Jerome Powell back to the familiar "Fed put" playbook. By pricing cuts within six months of the peak rate, they are assuming the committee regards even a mild recession as unacceptable.

The traders have a track record to point to. In December 2018 the Fed's projections showed two more rate rises for the following year. Share prices fell by nearly 20 per cent from their autumn peak, the Fed paused within weeks, and it ended up cutting three times in 2019. Anyone who trusted the dots then lost money.

This time the bet misjudges how much it hurt the Fed to let inflation reach 9 per cent. For Powell's FOMC, the damage to its reputation from cutting too early and watching inflation come back, as it did in the 1970s, far outweighs the cost of a modest downturn. In 2018 core inflation was running close to target and the Fed could afford to be flexible. Today it is more than twice the target, and Powell used his Jackson Hole speech in August to warn against repeating the 1970s mistake of loosening policy before inflation was beaten.

Loose markets undo tight policy

The market's bet is not harmless to the Fed, because monetary policy works largely through financial conditions. Mortgage rates, corporate bond yields and share prices all key off expected short rates, so pricing cuts early eases credit before the committee has chosen to. Thirty-year mortgage rates rose above 7 per cent in October and have fallen back since, largely on the hope of an earlier pivot.

That gives the Fed a reason to talk tougher, not softer. Every rally built on expected cuts loosens the conditions it spent the year tightening, and the committee's natural response is to push its projected peak higher or hold it for longer. The Fed is also still shrinking its balance sheet by up to $95 billion a month, a drain on liquidity that continues whatever the futures market thinks.

Other central banks agree

The Fed is not alone in its resolve. A day after its decision, the European Central Bank and the Bank of England each raised rates by half a point, and the ECB said it would begin shrinking its bond holdings in March. Christine Lagarde went further than markets expected in warning that more rises were coming. A coordinated hawkish tone makes it harder for any one central bank to change course quickly, since doing so would weaken its currency and import inflation.

One side has to give

The gap between the Fed's 5.1 per cent dot and market pricing is a source of volatility that nobody has hedged. If the Fed holds rates through 2023 as it says it will, short-term swap curves will have to reprice sharply higher, and funds positioned for easing will take heavy mark-to-market losses.

The losses would fall unevenly. Holders of two-year Treasuries and short-dated swaps would suffer most, since that part of the curve carries the most rate-cut pricing. Long bonds might hold up better, because a Fed that stays tight also raises the odds of recession, and the curve between two and ten years is already inverted by the most since the early 1980s.

The data that will settle the argument arrive quickly. Monthly payrolls and wage figures in early January, December's consumer prices a week or so later, and the Fed's next decision on 1 February will each show whether inflation is falling fast enough to justify the market's view. Two or three soft inflation prints would strengthen the traders' hand; a firm labour market would weaken it.

If the market is right and cuts do come, the likely cause will be serious breakdowns in the financial plumbing that force an emergency rescue, and a painless fall in inflation will have had little to do with it. This standoff cannot last. Bond traders will probably have to give in to the Fed's hawkish path during 2023, and if they do not, rates will fall only because something in the financial system has broken.