Fed’s Policy Path Back in Center of AttentionFebruary 22, 2023
Investors’ fears over a slowing US economy have seemingly been replaced with renewed fears over inflation and the possibility of a more hawkish stance by the Federal Reserve. Despite progress on lower goods inflation and signs that economy was cooling in December, price pressures have now picked up again along with signs of greater strength in the US economy. This has led investors to recalibrate their expectations for the Fed’s likely interest rate path for 2023, with negative results for US stocks.
Consequently, 10-year Treasury breakeven inflation (the market’s measure of inflation expectations) increased in February, breaking out to its highest level so far this year.
Increasing inflation expectations are a red flag for the Federal Reserve. FOMC committee members were out in full force last week, publicly addressing the need to get inflation under control by raising rates higher than the bond market had forecasted. The market finally got the message and is now pricing the Fed Funds rate closer to that of the Fed’s own survey of economic projections.
Below we see the bond market’s repricing of the expected Fed Funds rate for December 2023. The S&P 500 negatively reacted to this projection, pricing in a higher discount rate and making stocks less attractive to investors on the margin.
Last month the market had convinced itself that December’s dreary economic growth numbers meant the Fed would risk a recession with its bold call for higher rates. Now it appears investors have recalibrated from fears over recession to renewed inflation worries. Strong economic numbers and a slowdown in disinflation have put the Fed’s policy path back in center of attention.