After the Fed increased its policy rate once again last week, we found the words the Fed and Chair Jay Powell used to explain the hike provided more insights than the action itself. Those words suggest that the Fed remains intent on more restrictive policy than what appears investors are assuming. What's behind this difference in views, and what could it mean for investors? Let's take a closer look.

Futures prices suggest that most likely the Fed will raise rates only once more this cycle. Meanwhile, the Fed's statement noted the likely need for ongoing increases which clearly says more than one increase. In addition, Powell said he doesn't expect any cuts this year which contradicts the market's view based on futures prices that the Fed is likely to start cutting this year. What gives? How will this debate be settled?

We don't think the difference in views is about investors questioning the Fed's resolve to bring inflation down. Indeed, market pricing and information gleaned from surveys suggest that the public believes that the Fed will restore price stability. This seems more like a question of the Fed's outlook for inflation. The market appears to believe that inflation will come down more quickly than the Fed expects requiring less restrictive monetary policy than the Fed is anticipating.

The resolution of this debate is, of course, highly consequential for investors. If the Fed is right and inflation falls more slowly than investors are expecting, then the Fed likely will raise rates further than the market expects and won't cut rates later this year, potentially weighing on bond and equity prices and the economy. Conversely, if the market is right on inflation and the Fed eases up, we think the odds of an economic soft landing improve. Powell suggests that the outlook for inflation may come down to what happens to the prices of non-housing core services, things like restaurant meals, hotel rooms, and doctor visits.

He noted that while inflation in goods is already easing and inflation in housing services is showing early indicators of abating, there are no clear signs yet of an easing in non-housing core services. And he reiterated that this inflation component is closely connected to conditions in the labor market, which he continued to characterize as extremely tight. So for the Fed, it's all eyes on non-housing services inflation and the labor market. Investors keen on the direction of rates would do well to follow suit.

Subscribe to MarketScape

Contact Us