Friday's Market Minute: Fed's Projections on Rates & Inflation are Disconnected

Looking back in time a year ago, it was clear the Federal Reserve needed to aggressively raise borrowing costs to reduce inflationary pressures on the economy. As inflation pressures slowly subside and the Fed reaches its current policy plateau, the risks of raising rates to a more-than-sufficiently restrictive level becomes an impediment to economic growth. Higher rates are not going away any time soon, as the economy remains resilient and core inflation will take time to gradually subside.

The FOMC meeting concluded as expected with no additional rate hike, but the market’s response suggests a disconnect between the Fed’s revised projections on interest rates and inflation. The median estimate of the Fed’s 19 policymakers is for the bank’s benchmark rate to fall to just 5.0%-5.25% next year. That was significantly higher than the 4.5%-4.75% they signaled when the dot plot was last updated in June. What they’re saying here is if you have stronger growth for this year and next, it increases the risk that core inflation does not fall as much expected. Despite maintaining tight monetary policy, the FOMC predicts economic growth will remain relatively robust and the unemployment rate will not materially rise.

As of July, the core Personal Consumption Expenditures price index hovered at 4.2%. Taking into consideration that consensus expectations are for core inflation to gradually fall, the current Fed Funds target between 5.25 and 5.5% is above core inflation by more than 1%, which is appropriately restrictive at current levels. In addition to the current target rate relative to recent core inflation data, the Fed forecast for core inflation is to ease further towards 3.7% from June’s forecast of 3.9% by the end of the year.

While the Fed’s forecast for inflation was lowered, their projections on rates are higher. According to the Fed’s median dot plot, the most likely interest rate projection for the December 2023 meeting is now 5.5%- 5.7%. However, the Fed Funds futures market is currently pricing in a greater than 50% probability of no additional rate hike this year, which implies a disconnect between the Fed’s intended end-of-year target rate and what the market deems appropriate. In a nutshell, the selling in both bonds and stocks since Wednesday is the market’s response that moderately suggests any supplementary rate hike based on current data is leaning towards a policy error that could pressure the economy into a recession.