As fears about out of control inflation have eased, the markets now see a greater chance of a 50bps hike at the September 20-21 Fed meeting. Previously a 75bps move was the more likely outcome. Then markets then expect a similar 50bps move up in November followed by a smaller 25bps hike in December. This is based on data from the CME’s FedWatch Tool. The real uncertainty concerns where rates will move in 2023 with a far broader set of outcomes depending on the trajectory of inflation and the U.S. economy.
Though the high rate of U.S. inflation is not over, falling oil prices since mid-June imply that inflation is easing based on recent CPI and PPI data. Stocks have also broadly moved up since then. The good news is oil prices have generally drifter lower in August too, so that should help soften the August inflation number, though perhaps not to the same degree as July. Plus natural gas prices are currently spiking, which may offset some of the downward move in oil.
Of course, questions remain about exactly where inflation will settle after this spike, and some categories of expenditure, such as food, continue to show steep price rises. Still, recent data suggests that inflation, in aggregate, could be coming under control, even if it will take some time to return to the levels the Fed wants to see.
This does not mean that the Fed will stop raising rates, but instead that the market sees the Fed increasing rates at a less aggressive pace for three remaining meetings of 2022.
2023 Remains The Question
For 2022, the main question is how fast the Fed raises rates. Then in 2023 the analysis changes, the markets lack conviction about the direction of interest rates.
The markets see a roughly even split between three scenarios. First the Fed may hold rates steady at around 3.5% after raising rates throughout 2022. In this case the economy holds up enough that the Fed doesn’t need to cut rates, but inflation likely remains an issue.
A second alternative is that the Fed starts to prioritize recession risks and a softer jobs market and starts to cut rates in 2023. This would happen if job market data and other economic indicators starts to show real weakness.
The third scenarios is that that the Fed continues to want to focus on inflation, perhaps due to additional supply chain issues and resource bottlenecks, and rates continue to trend up, but at a slower pace with one or two 25bps increases in the first half of 2023.
The broad range of divergent scenarios suggest that the markets have no clear view as to which path the Fed will take next year….