The interest-rate market has a dirty secret, which practitioners call “the hairy chart”. Its main body is the Federal Reserve’s policy rate, plotted as a thick line against time on the x-axis. Branching out from this trunk are hairs: fainter lines showing the future path for interest rates that the market, in aggregate, expects at each moment in time. The chart leaves you with two thoughts. The first is that someone has asked a mathematician to draw a sea monster. The second is that the collective wisdom of some of the world’s most sophisticated investors and traders is absolutely dreadful at predicting where interest rates will go.
Since inflation began to surge in 2021, these predictions have mostly been wrong in the same direction. They have either underestimated the Fed’s willingness to raise rates or overestimated how quickly it will start cutting them. So what to make of the fact that, once again, the interest-rate market is pricing in a rapid loosening of monetary policy?
This time is different, and in an important way. A year ago investors betting that rates would soon be cut were fighting the Fed, whose rate-setters envisaged no such thing. Then, in December, the central bank pivoted. Rate cuts were now being discussed, announced Jerome Powell, its chairman, while officials forecast three of them (or 0.75 percentage points’ worth) in 2024. The market has gone further, pricing in five or six before the year is out. It is, though, now moving with the Fed, rather than against it. Mr Powell, in turn, is free to make doveish noises because inflation has fallen a lot. Consumer prices rose by just 3.4% in the year to December, compared with 6.5% in the year before that.
Yet the past few years have shown how eager investors are to believe that cuts are coming, and how frequently they have been wrong. And so it is worth considering whether they are making the same mistake all over again. As it turns out, a world in which rates stay higher for longer is still all too easy to imagine.
Begin with the causes of disinflation to date. There is little doubt that rapidly rising interest rates played a role, but the fading of the supply shocks that pushed up prices in the first place was probably more important. Snarled supply chains were untangled, locked-down workers rejoined the labour force and soaring energy prices fell back to earth. In other words, negative supply shocks gave way to positive ones, cooling inflation even as economic growth rebounded.
Yet these positive shocks are now themselves fading. Supply chains, once untangled, cannot become any more so. America’s participation rate—the proportion of people in its labour force—increased from 60% in April 2020 to 63% last August, but has since stopped rising. Meanwhile, energy prices stopped falling early last year. And escalating violence in the Middle East, where America and Israel risk being drawn ever further into conflict with proxies and allies of oil-producing Iran, could yet cause prices to start rising again. All of this leaves monetary policy with more work to do if inflation is to keep falling.
At the same time as America’s participation rate has stopped rising, wages have continued to climb. According to the Atlanta Fed, in the fourth quarter of 2023 median hourly earnings were 5.2% higher than a year before. After adjusting for inflation, this is well above the long-run annual growth rate for workers’ productivity, which has been a little over 1% since the global financial crisis of 2007-09. A gap between wage and productivity growth will, all else equal, continue to force up prices. For the Fed, this makes rate cuts harder to justify.
The case that rates may stay high is therefore plausible even if you ignore the political backdrop. In an election year, that is a luxury which central bankers do not have. The danger of easing monetary policy too early and allowing inflation to come back, as happened in the 1970s, already looms over the Fed. During a presidential campaign featuring Donald Trump, cutting rates too quickly could have even graver consequences. The cry would inevitably go up that officials had abandoned their mandate in an attempt to juice the economy, please voters and keep Mr Trump out of office.
And Mr Trump may well win, in which case he will probably pursue deficit-funded tax cuts, driving inflationary pressure yet higher and forcing the Fed to raise rates.Such a scenario is still, just about, speculative fiction. It is certainly not what investors expect. But when you look at their predictive record, that is hardly a comfort.■
Correction (January 25th 2024):An earlier version of this article mistakenly suggested that consumer prices rose by 6.5% in the month before December. In fact, they rose by 6.5% in the year to December 2022. Sorry.
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Also: How the Buttonwood column got its name
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This article appeared in the Finance & economics section of the print edition under the headline "Monetary mistakes"
January 27th 2024
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From the January 27th 2024 edition
Discover stories from this section and more in the list of contents
Explore the editionAs an enthusiast and expert in financial markets and monetary policy, I bring a wealth of knowledge and experience to analyze the intriguing dynamics outlined in the provided article. I have closely followed the developments in the interest-rate market and have a deep understanding of the factors influencing market expectations and central bank decisions.
The article dated January 24th, 2024, delves into the interest-rate market's "dirty secret" known as the "hairy chart." This chart represents the Federal Reserve's policy rate plotted against time, with faint lines branching out to depict the market's collective expectations for future interest rates. It highlights the challenges in predicting interest rate movements, particularly in light of recent trends where predictions have consistently erred in the same direction.
The central theme revolves around the current market pricing in a rapid loosening of monetary policy, a departure from previous expectations. The Federal Reserve, led by Chairman Jerome Powell, has shifted its stance, openly discussing and forecasting rate cuts. However, the market seems to be going even further, pricing in more aggressive cuts than officially indicated.
The article emphasizes that the current situation differs from the past, with the market now aligning with the Fed's expectations rather than resisting them. Powell's ability to adopt a dovish stance is attributed to a significant decrease in inflation, with consumer prices rising by just 3.4% in the year to December, compared to 6.5% in the previous year.
The author raises a crucial question: Are investors once again making the mistake of assuming rate cuts are imminent? The argument presented suggests that, despite the recent disinflationary factors, there are reasons to believe that rates may not decrease as anticipated.
The causes of recent disinflation are explored, attributing it not only to rising interest rates but also to the fading of supply shocks that initially drove prices higher. However, the article points out that positive supply shocks are now diminishing, leaving monetary policy with the task of sustaining the downward trend in inflation.
One critical factor contributing to the complexity of the situation is the stagnant participation rate in the U.S. labor force, coupled with continuing wage growth. The article, citing data from the Atlanta Fed, highlights that median hourly earnings were 5.2% higher in the fourth quarter of 2023 compared to the previous year. This wage growth, exceeding the long-run annual growth rate for productivity, could put upward pressure on prices, making rate cuts more challenging for the Federal Reserve to justify.
Moreover, the article introduces a political dimension, discussing the potential challenges for the Fed in an election year. Easing monetary policy too early could lead to accusations of abandoning the mandate and manipulating the economy for political purposes. The risk of allowing inflation to return, reminiscent of the 1970s, adds another layer of complexity.
In conclusion, the article suggests that the expectation of rate cuts might be premature, and a scenario where rates stay high is plausible, especially when considering the political backdrop. This nuanced analysis showcases the intricate interplay between economic indicators, monetary policy, and political considerations, underscoring the challenges in making accurate predictions in the complex world of financial markets.
