A team of Federal Reserve economists have a troubling message for markets: interest rates could be kept above 5% for much longer than investors are anticipating. Perhaps until 2026.
That is the conclusion of a paper published late last week by Johannes Matschke and Sai Sattiraju, two economists with the Kansas City Federal Reserve Bank. The paper caught the attention of Apollo Global Management Chief Economist Torsten Slok, who mentioned it in a note to clients shared with MarketWatch on Monday.
“The main message in this paper is that to get inflation down to 2%, interest rates will have to stay higher for longer than markets currently are pricing,” Slok said in emailed commentary.
In addition to this dire forecast, the report’s authors also offered an explanation for why the U.S. economy has continued to expand despite the Fed hiking rates by more than 5 percentage points since March 2022.
Although the Fed tightened policy at the fastest clip since perhaps the 1980s over the past year, rapidly accelerating inflation drove the equilibrium level of interest rates in the U.S. economy higher even more quickly, the economists said. Because of this, policy didn’t enter restrictive territory until the first quarter of 2023.
With the pace of economic growth still so robust — U.S. GDP expanded at an annualized rate of 2% during the first quarter, according to the latest estimates — the Fed might need to keep rates at or above current levels for more than three years to bring the Fed’s preferred inflation gauge, the PCE index, back to the central bank’s 2% target.
As Slok pointed out, this could complicate the market’s first-half rally, potentially causing the S&P 500 to reverse some of its nearly 16% year-to-date gains as investors adjust to the notion that interest rates won’t be coming down soon.
Inflation slowed to a 12-month rate of 3.8% in May, according to the latest reading on the PCE index, released Friday. That marked the slowest pace since April 2021. That is a sharp turnaround from one year ago, when inflation accelerated to its fastest pace in more than 40 years.
Traders expect the Fed will raise interest rates at least once more this year, according to the CME’s FedWatch tool, which infers traders’ expectations based on activity in the Fed funds futures market. Fed Chair Jerome Powell has said that senior Fed officials responsible for managing monetary policy expect two more hikes in 2023. The fed-funds rate target’s upper bound currently stands at 5.25%.
Powell said last week that he doesn’t expect the rate of inflation to return to the Fed’s 2% target until 2025, implying that the Fed won’t cut rates until some time after that. But Fed funds futures markets suggest traders are once again refusing to take the central banker at his word, and are instead penciling cuts to arrive in 2024.
Powell has reiterated again and again that the Fed wants to make sure inflation has been defeated before beginning the process of cutting interest rates once again to avoid repeating policy mistakes made by his predecessors in the 1970s.
U.S. stocks traded mostly higher on Monday, with the S&P 500
SPX,
up 0.1% and the Nasdaq Composite
COMP,
down 0.1% ahead of an early 1 p.m. Eastern Time close.
See: Is the U.S. stock market closed on the Fourth of July?
The Dow Jones Industrial Average
DJIA,
was up 45 points, or 0.1%.
Read the full article here