By J. Keith Buchanan, CFA, Senior Portfolio Manager
There is a question that risk markets have been wrestling with all summer and now into the fall. As inflation exploded onto the economic scene in 2021 and proved itself to be stickier than first expected, US monetary policymakers at the Federal Reserve tightened policy by 450 basis over the course of twelve months. In 2022 at last, year-over-year inflation started moving lower toward the Fed’s 2% target.
However, this summer has complicated the path forward for inflation, and as a result, the path forward for monetary policy. Federal Reserve Chair Jerome Powell has expressed time and time again that the error that the committee most desires to avoid is a resurgence in inflation. He stated that plainly as inflation moved higher in 2021 almost as a warning as to how dramatically hawkish Fed policy would become over the next year. Even as the market and policy makers applaud the disinflationary shift that has occurred and priced in the peak Fed Funds rate near the current level, the end of summer brought with it fears that rates will stay here for longer than the market previously expected.
The August Consumer Price Index report showed some pockets of potential reacceleration largely due to the uptick in energy prices. The August Producer Price Index also came in higher than consensus expectations. As recently as August 8th, Fed Funds futures were pricing in that the Fed Funds rate would finish 2024 at 3.75-4.00%. In other words, the market expected 150 basis points of cuts to the Fed Funds rate in 2024. Today, just a month and a half later, the market expects 75 basis points of cuts to the Fed Funds rate next year.
Risk markets readjusted lower throughout 2022 as they digested just how high the Fed was willing to take interest rates, and the potential havoc those hikes could wreak on our economy. Going forward, the rest of 2023 may be defined by how well the markets adjust to rates staying higher for longer. How much longer though? The market is increasingly betting that the Fed will remain in this restrictive stance further into next year. That anticipation has lifted 10-year Treasury rates to new 15-year highs and placed new pressure on equity prices over the past two weeks. However, a resurgence of inflation could prompt policy makers to delay rate cuts and dovish rhetoric even further. Recessionary fears or cascading inflation could have the opposite affect and offer relief to equities and fixed income assets.
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