The Fed and the markets are in a bind about raising interest rates

Washington – Sooner or later, Wall Street or the Federal Reserve will have to blink.

After nearly a year of the Fed campaigning to crush inflation by raising interest rates at a blistering pace, investors still don’t quite believe what the Fed warns is coming next: higher rates through the end of the year, which could lead to a sharp rise in interest rates. Unemployment rate and slow growth.

Wall Street has a more optimistic view: With inflation declining from painful highs, investors are betting that the Fed will stop raising rates soon, pause for a while and then start cutting rates at the end of the year to combat what many on Wall Street expect. It will be moderate slack. The relatively optimistic view helped push S widely& P500 stock index is up 4.4% so far this year.

However, a slew of Fed speakers last week emphasized a contradictory message: They expect to raise the benchmark interest rate above 5%, just above Wall Street expectations. Doing so is likely to lead to higher borrowing rates for consumers and businesses, from mortgages to auto loans to corporate credit. Moreover, some Fed officials have reiterated that they plan to peg exchange rates at a higher level until the end of this year.

The gap between the Fed’s forecast and Wall Street’s forecast could have far-reaching consequences for Americans’ finances as well as for the economy.

For investors, price cuts work almost like blows on steroids. They make borrowing less expensive, and they usually set prices for everything from stocks to bonds to cryptocurrencies. This is why investors are so hungry to know when the next rate cut will be, hoping to get ahead and make the most of the resulting rise in stock and other asset prices.

On the other hand, if the Fed follows through on its warnings about still higher rates, the economy may not only slip into recession, but endure a deeper and longer recession than it would have if it followed the market’s course instead.

Wall Street investors were encouraged by the assumption among economists that when it meets next week, the Fed will raise its benchmark rate in smaller increments, just a quarter of a point. That would mark a downward turn from the half-point rate hike the Fed imposed in December and four consecutive three-quarter point rate hikes before that.

Fed officials predicted that the key short-term interest rate, now between 4.25% and 4.5%, would eventually reach 5% to 5.25%. By contrast, the futures markets show that the majority of investors expect the rate to peak at 4.75% to 5% – if not lower.

“Obviously the way the market is looking at this is the lower you shift, the closer you are” to ending the rate hike, said Michael Jabin, chief US economist at Bank of America. Less likely you will get some,” because the economy may enter a recession and discourage further increases before the Fed can implement them.

Wall Street investors appear confident that the Fed has whipped up inflation to such an extent that further rate hikes are unnecessary. By some measures, investors think inflation could fall to close to 2% — from 6.5% now — by the end of this year, according to Deutsche Bank. By contrast, Fed policymakers collectively projected that inflation would remain 3.1% by the end of the year.

“The market has a very optimistic view that inflation is going to fade,” Christopher Waller, a member of the Federal Reserve Board of Governors, said last week. “We have a different view. The process of bringing down inflation will be slower and more difficult. Thus, we have to keep rates higher for a longer period and not start cutting prices by the end of the year.”

Waller and other Fed officials point to the strength of the labor market as a factor likely to keep inflation high. The unemployment rate, now 3.5%, hasn’t been lower in half a century. Companies continue to raise wages to keep and attract workers, which usually results in higher consumer spending. Employers, in turn, typically pass higher labor costs on to their customers in the form of price increases. Either way, the Fed fears, will keep inflation well above its 2% target.

Many traders also say they expect the Fed to back off once unemployment starts to rise steadily while inflation drops. With millions of people likely to face layoffs, the Federal Reserve will be under pressure to start cutting interest rates to try to stimulate the economy.

“Markets have become very accustomed to their policy of easing at the first sign of trouble,” said Gennadiy Goldberg, chief interest rate strategist at TD Securities.

But this time, Goldberg said, the Fed “needs to see the pain in order to bring down inflation.” Federal Reserve officials expect the unemployment rate to reach 4.6% by the end of this year, which could see nearly 1.5 million people lose their jobs. As a result, Goldberg said, “they are almost unable at present to facilitate the achievement of their policy objectives.”

“It’s going to be an interesting decoupling once the economy really starts to slow down,” he said. “I think you’re going to have some investors who are going to be very disappointed.”

John Canavan, market analyst at Oxford Economics, suggested that the yield on the 10-year Treasury note could rise higher, from its current level of around 3.5%, to 3.7%, if the Fed raises interest rates above what the market expects. Mortgage rates will rise, at least in the short term.

In a series of speeches last week, several Federal Reserve officials expressed optimism that inflation is receding faster than they expected. After peaking at 9.1% in June, 12-month inflation measures have eased for six consecutive months to 6.5%.

However, those officials, including Chairman Jerome Powell, have stressed the need to avoid holding interest rate increases too early for fear that inflation will accelerate again and then require tougher policy steps. They want to prevent the mistakes of the 1970s, when the Fed raised interest rates, only to lower them once unemployment rose but before high inflation was decisively crushed.

Any slowdown by the Federal Reserve could trigger a major rally on Wall Street, with stock prices soaring and bond yields falling. This possibility, as welcome as it is for investors and businesses, is something the Fed wants to avoid: It could lead to excessive spending and possibly reignite inflation.

If investors get too excited about low inflation and markets pick up, said Lori Logan, President of the Federal Reserve Bank of Dallas, the Fed may have to raise interest rates higher than expected.

But the central bank’s determination to keep interest rates high coincides with recent evidence of a slowing economy, renewing fears that a recession could soon begin. Consumers have reduced their spending at retailers for two consecutive months. Factory production fell sharply in November and December. Home sales have fallen for 11 consecutive months, and last year marked their lowest level in nearly a decade.

However, a recession may prove markets right in the end, because an economic downturn — especially a deep one — can lower inflation much more quickly than the Fed expects. And while Fed policymakers have said they intend to continue raising interest rates, they have also said they may stop hiking if the economy’s course changes.

“If the inflation rate drops faster than I expect it to, I may have to adjust my current policy path,” Loretta Mester, chair of the Cleveland Federal Reserve, said in an interview with The Associated Press last week.

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Choi reported from New York.

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