The US Federal Reserve (Fed) has upcoming rate decisions on February 1, March 22 and May 3. Despite the Fed’s conviction that inflation remains a major concern, the markets are less convinced that many more hikes are coming based on recent reports showing inflation easing . Markets suspect that the Fed will soon be done raising rates, perhaps as soon as the May 3 rate decision.
In December 2022, the Fed indicated that rates are likely to exceed 5% in 2023, but the markets don’t see it. The markets believe we’ll most likely see a 0.25-percentage-point hike at both the February and March meetings, but that could be the end of hikes for this interest rate cycle. In fact, the Fed may even cut rates in November or December of 2023, based on interest rate futures. Ironically, that’s something the Fed explicitly said at their last meeting they won’t do.
Points Of Contention
There are two primary areas of disagreement between what the Fed recently projected and what the markets think will occur. The first is the Fed Funds rate. In December, a majority of Fed policymakers forecast that rates would exceed 5% this year. However, the markets see a much smaller, 1 in 3 chance of this happening. It’s certainly possible, but not the main scenario in the eyes of the bond market.
Cuts In 2023?
The second issue is whether we’ll see an interest rate cut in 2023. The Fed was clear during its December meeting, with no policymaker predicting interest rate cuts in 2023. However, the market doesn’t buy that, believing there’s some chance the Fed does decide to cut rates by December. Now, rate cuts are not something the market views as certain, and both the Fed and markets expect rates to hold at high levels for most of 2023.
Still, by November or December, the markets suspect the Fed will be tempted to cut rates. Optimistically, that may happen because inflation is well under control and the Fed’s work fighting inflation is done. More pessimistically, maybe a recession convinces the Fed that high rates are damaging to the economy, forcing a rate cut.
It’s also worth noting that the Fed and markets are fairly aligned overall for 2023. Both the Fed and markets expect more hikes during the early meetings of 2023, and for rates to hold steady for much of the year. The areas of contention really are the May, June and July meetings, when the markets expect the Fed to be done raising rates, and holding them steady, whereas the Fed’s own projections imply that some, or maybe even all, of those meetings could involve further 0.25-percentage-point rate hikes.
Come the end of the year, in November or December, the Fed expects to be holding rates steady as inflation moves back to its 2% target. In contrast, the market believes the Fed could be tempted to nudge lower rates, perhaps based on concerns around a US recession. However, here the controversy is not too great. Again, the markets only see a 1 in 3 chance that the Fed decides to cut rates, and even then, by a small amount in November or December.
Of course, both the Fed and the markets will react to incoming data. The markets expect that inflation numbers, and related data, will continue to assure the Fed that inflation is moving back to the Fed’s 2% goal.
The Fed is less keen to declare victory too early and continues to worry about wage inflation, price markups, trends in service inflation and other risks for the inflation picture.
Meetings To Watch
Based on these worries, the key 2023 Fed meetings to watch most closely may be those in May and December. Fed leaders have hinted that in May they may raise rates once again, but markets think this could be the first of several meetings where the Fed holds rates steady.
Then looking to the Fed’s December meeting, the markets think the Fed may be tempted to cut rates. This isn’t the central case, but there’s a chance of it happening according to the implicit projections of the bond market. The Fed isn’t willing to contemplate 2023 rate cuts yet. Nonetheless, both markets and the Fed are aligned that after a few more small increases, rates should hold steady for much of 2023.
Equally, it’s worth noting in the past, both the Fed and markets have been wrong, and incoming economic data will have far more weight in driving monetary policy than either the Fed’s or the markets’ implicit predictions.