The Market And Fed: Diverging Expectations

It’s extremely difficult to guess what monetary policy will be in 2022 and 2023 because the Fed has a new policy prescription and we don’t know how quickly the economy will ramp up. The Fed has historically looked for 2% core inflation, but now it wants core inflation to average 2% for the cycle which implies it wouldn’t have raised rates at all last expansion. We wonder if the Fed would have gone through with that over the 10+ year expansion (had that been its policy). If the Fed had never raised rates, it wouldn’t have been able to cut them early last year. We learned last year that the Fed almost never can run out of ammo in a crisis. That makes it less necessary to worry about how the Fed will respond to a future recession if rates are low. (The Fed doesn’t need to raise rates so it can cut them in a crisis).

This is a very perplexing scenario because in a previous article we laid out that if the Fed doesn’t hike rates until the 3-year average core PCE inflation rate gets to 2%, it probably won’t hike them in 2022 or 2023 because 2020’s low numbers will drag the average down. With that understood, it’s odd to see the market pricing in rate hikes so soon. In the past couple of weeks, the market has moved towards expecting more rate hikes and having them start sooner. There are now 80% odds for a quarter-point hike in 2022 and two hikes in 2023. By the end of 2024, the market sees five hikes in total.

The market doesn’t think the Fed will follow through with its new average inflation target. The next Fed meeting is from March 16th to the 17th. It will be very interesting to see how much it tries to talk down the odds of hikes while still recognizing the improved economic outlook. It would be much easier for the Fed if the February labor report ends up being terrible. We don’t think it will be terrible. The median forecast is for 210,000 jobs created. It would be weird for the Fed to go out of its way to be extremely dovish as the economy is showing signs of bouncing back. However, that’s what is necessary to alter the Fed funds futures market.

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