Valentine's Day: Markets still love rate cuts. The Fed doesn't love them back

January's consumer prices rose at a 6.4 per cent annual pace, the Bureau of Labor Statistics said on Valentine's Day, and markets' eighteen-month infatuation with Federal Reserve rate cuts was once again shown to be one-sided. Traders have bought every dip in risk assets on the hope of a dovish turn, reading each soft data point as a sign that Jerome Powell would soon come to the rescue. Central bankers have made plain that they feel nothing of the sort. The Fed is committed to its inflation target, and markets are trading a fantasy.

A habit fifteen years deep

The fixation on rate cuts is a habit learned over fifteen years in which every market wobble brought emergency liquidity. Investors came to believe that central banks were there to prop up asset prices.

The habit has deeper roots still. Alan Greenspan's Fed cut rates after the 1987 stock market crash and again after the collapse of Long-Term Capital Management in 1998, and traders coined the phrase "Greenspan put" for the pattern. After 2008 the Fed held rates near zero for seven years and bought trillions of dollars of bonds, and in March 2020 it cut to zero and bought assets on a scale never seen before within days of the pandemic hitting markets. An entire generation of traders has never worked through a cycle in which the Fed refused to respond to falling share prices.

A one-sided affair

That belief ignores how badly the current bout of inflation has shaken policymakers. With inflation at 6.4 per cent, the Fed cannot ease to protect equity valuations or to head off a mild recession.

The rescues of the past worked because inflation was low. When prices were rising by 2 per cent or less, the Fed could cut to support markets at little risk to its mandate. Today inflation is more than three times its target, and the central bank's own forecasters were badly wrong about how long it would last. The same officials who called the surge transitory in 2021 are determined not to make a second error by declaring victory too soon.

For the Federal Open Market Committee, an early cut would risk a fresh surge in commodity and wage inflation and would wreck the price-stability credibility it has fought hard to rebuild. What the Fed does next depends on inflation data, and share prices hardly enter into it.

What January's data said

The details of the January report gave the optimists little comfort. Prices rose 0.5 per cent in the month, and shelter costs, which make up about a third of the index, were again the largest contributor. Energy prices ticked up after several months of declines, and core services prices kept climbing at a pace consistent with a tight labour market. A week earlier the government had reported that employers added 517,000 jobs in January.

Put together, the figures describe an economy that has absorbed a year of rate rises without the slack the Fed needs to see. The central bank raised rates by a quarter of a point on 1 February, to a range of 4.5 to 4.75 per cent, and officials' projections from December point to a peak a little above 5 per cent with no cuts this year. Markets have spent the winter betting against those projections, and the data keep siding with the Fed.

Rallies will keep fading

So long as the two sides stay this far apart, each rally in risk assets is likely to be snuffed out by hawkish speeches and higher policy rates. Markets that price in cuts will keep having to take them back out.

The pattern has repeated several times already. Share prices rose sharply in the summer of 2022 on hopes of a pivot, only for Mr Powell to deliver a blunt speech at Jackson Hole in August promising to keep going; the rally collapsed. Markets rallied again in the autumn and the new year, and each time the next set of data or the next round of speeches pulled pricing back. Each reversal has hit hardest the assets most dependent on cheap money, such as unprofitable technology shares and long-dated bonds.

Where the market could be right

The strongest case for the market's view is that monetary policy works with long lags, and the Fed may already have done enough. Rates have risen faster than at any time since the early 1980s, and the full effect on borrowing, hiring and investment has yet to be felt. Money supply has been shrinking, the housing market is in a steep downturn, and goods prices are falling. If something breaks in the financial system, the Fed would cut regardless of inflation, as it did in 2020.

That argument deserves respect, but it points to cuts forced by a crisis or recession, which is hardly the gentle outcome equity investors are pricing. A market that wants both cheaper money and resilient corporate profits is asking for two things that rarely arrive together. When the Fed has cut in the past with inflation still high, it has usually been because the economy was deteriorating fast.

Winners from a stubborn Fed

For savers, the Fed's stance is a gift. Treasury bills and money market funds now yield more than 4.5 per cent with little risk, and the case for holding cash has not been this strong since before the 2008 crisis. The losers are borrowers on floating rates, companies that need to refinance this year and investors paying high multiples for earnings that lie years in the future.

This split between market hopes and Fed policy will not be settled by amicable negotiation. The Fed has no intention of returning Wall Street's affection for cheap money. Until the labour market weakens and inflation is clearly falling, policy rates will probably keep rising this year and then stay high for some time. Expect at least two more increases at the spring meetings, a peak above 5 per cent by the summer, and a string of disappointments for traders who keep pricing cuts before the year is out.