All eyes have been on the Federal Reserve (Fed) for a very long time. The Global Financial Crisis in 2008 ushered in an era of ultra-loose monetary policy where interest rates around the globe were at, or near, zero for well over a decade. During that time, central banks like the Fed had the luxury of very low inflation, allowing them to keep interest rates low without the fear of upward spiraling prices.
Today, the environment is very different. Inflation remains above the Fed’s comfort level and additional rate hikes are all but certain. This week we highlight an important dynamic relative to the Fed’s likely path. The first chart below shows the large increase in expectations for where the Fed Funds rate will be at the end of this year. A strong labor market and a hotter than expected inflation reading caused this readjustment in expectations. Usually, when rate hike expectations increase future inflation expectations decrease. This is somewhat intuitive, as tighter monetary policy should reduce future inflation. However, as seen in our second chart, inflation expectations have continued to move higher. If this pattern were to continue it would signal a lack of faith in the Fed’s ability to get inflation under control. In our view, the Fed is keenly aware of this dynamic and does not want to risk a loss of credibility. On balance, this makes us believe that short-term interest rates will continue to rise and the Fed’s message to the market will be that they are committed to further reducing inflation.
In our opinion, this remains a challenge for a stable advance in equity markets.
Investors have increased their expectations for the terminal fed funds rate…
however, inflation expectations continue to rise.
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