Who is behind the curve?

At the previous meeting, FED kept rates unchanged and the pace of its bond buying program, which is currently snapping up $60 billion each month.

The criticism that the Fed is behind the curve on inflation seems justified. PCE inflation of 5.7% in November 2021 was the highest in nearly 40 years and nearly three times the 2% target, and the Fed is still easing policy! Sure, its asset purchases are growing smaller, but the point remains that, on the surface, the Fed seems to be miles behind the curve, and that’s maybe one of the reasons why risk assets, like stocks have been pulled through the wringer so far this year.

However, this argument does not stack up because market pricing suggests that the Fed is actually being too aggressive. While FOMC median forecasts indicate that the fed funds target will rise to more than 2% (the end-2024 median Fed forecast is for 2.0%-2.25%), money markets are calling a halt around the 1.75% level.Hence, if you are of the opinion that the Fed is behind the curve and will have to lift rates faster, or by more, or both, then the market is even further behind the curve.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy is firmly in the camp of those that think the Fed – and the market – are behind the curve. As the Fed turns more hawkish, as it has done over the last few meetings, the market will move with it. But the problem is that the market is coming kicking and screaming even as inflation breaches ever higher levels. Could this be down to the fact that very few traders and investors have really experienced inflation? You have to go back to the 1970s and early 80s to see the sorts of price numbers we are seeing now in the US and many other nations. Since then, there have been accusations of central bankers falling behind the curve, such as former Fed Chair Greenspan during his long run, but the only explosions in prices that resulted from excessive monetary easing under his watch were in assets like stocks and, notoriously, housing, up to the point that the global financial crisis broke (which was under Ben Bernanke’s watch, of course).

Fast forward to today and the market seems to be suggesting that inflation in goods and services won’t stay high and will only require modest rate hikes to correct it. Is this because the market inherently views the surge in inflation as transitory and something that can be easily removed with the fed funds rate only moving up to around 1.75%? Or is it because the market is implicitly assuming that any faster Fed tightening will implode asset prices and bring an early end to the tightening cycle that way?

Mr. Steve Barrow said he can’t know the answer to this but, in his view, the possible explanation has probably shifted from the former to the latter. For a start, he has seen inflation not just rise but become persistent and more ingrained, as the Fed itself has acknowledged. On the other hand, asset prices have wobbled very badly in the last month, or so, and that’s both bonds and stocks.

Could these moves be more consistent with the idea of asset bubbles in both equities and bonds? Time will tell on this one. The danger, from here, is if holders of assets come to expect that significant weakness, particularly in stocks, will cause the Fed to go easy; to lean more towards the market view about the extent of this monetary cycle and less towards its own, more hawkish, interpretation.

"We say it is a danger because we don’t believe that the Fed is going to go easy, and that’s an important departure from the past when, for the most part, the Fed has blinked. This time around, inflation is not allowing it to blink. Many, including the IMF, will undoubtedly want the Fed to take it easy in order to help emerging markets avoid debt-related problems.But we just don’t see it; not today and not in upcoming meetings. And, if we are right about this, asset prices look as if they could be in for a protracted period of strain and not just some sort of early-year temporary setback", Mr. Steve Barrow said.