Data Alters Market's Expectations for Peak Policy Rate But Not Outlook for Fed Cuts

Surprisingly strong recent readings for U.S. employment and inflation have been notable for causing markets to rethink the path of U.S. Federal Reserve policy in some ways but not others.

Following the latest economic data, the Fed’s terminal policy rate implied by short-dated interest rate forwards increased to about 5.3%, a level expected to be reached in the second quarter of 2023. But markets haven’t much changed the expected path of Fed rate cuts thereafter, still implying a reduction from that peak to roughly 3.65% by the end of 2024.

We think there is a reasonable narrative to support this expectation. Fed policy is currently restrictive and, over the next several months, will likely become even more so. But precisely because policy is restrictive, the threshold to normalize policy thereafter – returning it to levels that are neither restrictive nor expansionary – should not be all that high. Indeed, all it should take is for inflation to moderate. The disinflationary cycle, which is likely to accelerate in the second half of this year, will result in ex ante real short-term borrowing costs that are high by historical standards.

Markets and policymakers seem overly focused on the terms “easing” and “tightening.” Instead, we would suggest “normalizing.” This is more than semantics: Normalizing is different from returning to easy policy, as the required actions to maintain a level of restriction or neutrality are very different than actions to stimulate aggregate demand. We continue to think the bar to outright policy easing remains high. It’s likely to take a more pronounced recession.

Surprise and revise

Following the latest Federal Open Market Committee (FOMC) meeting on 1 February, Fed Chair Jerome Powell said the divergence between the path of the federal funds rate as implied by forward rate contracts and Fed officials’ latest Summary of Economic Projections from December was likely the result of “the market’s expectation that inflation will move down more quickly.”