Yellen Calls a Meeting with Top Financial Regulators
Treasury Secretary Janet Yellen convened a meeting on Friday morning of the Financial Stability Oversight Council (FSOC), an entity comprised of the nation’s top financial regulators that was created in the aftermath of the 2008 financial crisis as part of the Dodd-Frank Act. What, if any, announcement will be made following the FSOC meeting is unknown at the time of this writing. We will be appearing on our friend Larry Kudlow’s Fox Business show at 4:00 p.m. ET and will no doubt unpack any developments from this news.
The Market Is Convinced Fed Will Cut and Cut and Cut
The conviction that the Federal Reserve is done raising rates and will quickly pivot to cutting became even more extreme at the end of this week.
Prices of fed funds futures now imply around a 95 percent probability that the Federal Reserve keeps its rate target unchanged at the next meeting in May and nearly a 65 percent chance that the Fed cuts in June. The odds of a cut by the July meeting rise nearly 99 percent.
The Fed Says Economic Growth Will Slump But Rates Will Stay High
It was just two days ago that the Fed released the Summary of the Economic Projections (SEP) of the members of the Federal Open Market Committee. These showed that Fed officials expect that the midpoint of their rate target range by year’s end would be 5.1 percent, meaning they are planning on targeting a range of five percent to 5.25 percent. That would mean one more 25 basis point hike this year and no cuts.
A glance over at the dot plot highlights just how far removed market expectations are from those of Fed officials. This is the part of the SEP that records the individual estimates of numbers as anonymized blue dots. Not one of the dots is below the current target, and all but one is higher. There are ten dots at the 5.1 percent estimate and seven above that. In other words, not even the most dovish Fed official foresees a cut, and a substantial minority see significantly more tightening.
Pricing on Fed funds futures suggests an even bigger disconnect when looking out all the way to the end of the year. Currently, the derivatives imply 0.5 percent chance of even the most dovish projection turning out correct. There’s only around a 25 percent chance that the target will stay above four percent.
Why the big disconnect? What do markets see that Fed does not or vice versa?
Does the Market Think We’re Doomed?
One possibility is that markets expect a far worse turn in the economy than Fed officials. Fed officials are projecting the pace of economic growth to 0.4 percent for the year and unemployment to rise to 4.5 percent. That’s a pretty severe downturn since unemployment has averaged 3.5 percent in the last three months, and the economy is likely growing at least twice that rate. As we pointed out on Thursday, the Fed appears to be forecasting a couple of quarters of economic contraction if not outright recession.
There are plenty of reasons why Fed officials do not want to forecast a recession. For one thing, Chairman Jerome Powell still maintains that there exists “a path” to a soft landing. For another, the Fed is hesitant to appear to be rooting for a recession and the hardships recessions bring. By admitting that its policy choices are consistent with a recession, the Fed would be confessing to causing one.
But a jump of 100 basis points in the unemployment rate will likely feel like a recession. By some measures, there has never been a rise in unemployment of 50 basis points without triggering a recession. And we do not mean just two-quarters of contraction but a real, honest-to-God, National Bureau of Economic Research “recession” recession.
By forecasting multiple deep cuts in the Fed’s target for fed funds, the derivatives market might be sending a signal that this is all way too optimistic. Perhaps this merely reflects a deepening unease about the health of the banking system. If the Fed is underestimating the weight of tightened financial conditions from the banking crisis, perhaps the downturn will be much more severe and come on us much quicker than Fed officials think.
It would be a weird thing for the market to decide it knows better than the Fed. While we are far from the belief that bank supervisors have perfect information about the health of the banking system—as is anyone who remembers the 2008 financial crisis—Fed officials should know more than outsider market participants. We all have access to the same macroeconomic data, but the Fed has access to confidential financial data. It is not impossible that investors have sniffed out a vulnerability that Fed officials have missed, but the certainty of this conviction reflected in the odds of cuts implied by the fed funds futures seems unwarranted.
Maybe Powell Will Flinch
The other possibility is that the market just believes the Fed will relent in its pursuit of bringing inflation back down to two percent. A recent survey by Bank of America found that a large majority of investors believe that central banks will tolerate above two percent inflation if it means avoiding a recession. One in five investors think the Fed would tolerate above three percent inflation to dodge a recession.
Powell pushed back hard against this at the press conference this week, saying:
My colleagues and I understand the hardship that high inflation is causing, and we remain strongly committed to bringing inflation back down to our 2 percent goal. Price stability is the responsibility of the Federal Reserve. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all. Questions? [Emphasis added]
So far, the market seems to be saying that, yes, it has plenty of questions.
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