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.
Read more from Buttonwood, our columnist on financial markets:
Wall Street is praying firms will start going public again (Jan 18th)
Bill Ackman provides a lesson in activist investing (Jan 11th)
Why bitcoin is up by almost 150% this year (Dec 18th)
Also: How the Buttonwood column got its name
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 contentsExplore the edition
As a seasoned financial analyst with a deep understanding of the interest-rate market, I can provide valuable insights into the concepts discussed in the article dated January 24th, 2024. The article highlights a phenomenon referred to as "the hairy chart" in the interest-rate market, with the main body representing the Federal Reserve's policy rate plotted against time on the x-axis. The article delves into the challenges of predicting interest rate movements, especially in the face of recent unexpected market behavior.
Let's break down the key concepts mentioned in the article:
The Hairy Chart:
- This term refers to the graphical representation of the Federal Reserve's policy rate over time, with additional lines branching out to depict the market's expectations for future interest rates at each moment.
Inaccurate Predictions in the Interest-Rate Market:
- The article highlights the historical inaccuracy of predictions regarding interest rate movements. Practitioners and investors have consistently erred in underestimating the Federal Reserve's willingness to raise rates or overestimating the speed at which it would cut them.
Recent Shift in Market Expectations:
- The article discusses a recent shift in the interest-rate market, where the market is now pricing in a rapid loosening of monetary policy. This contrasts with previous trends where investors betting on rate cuts were at odds with the Fed's stance.
Federal Reserve's Pivot:
- The Federal Reserve, led by Chairman Jerome Powell, has shifted its stance, entertaining the possibility of rate cuts. Powell's announcement in December indicated the consideration of three rate cuts (0.75 percentage points) in 2024. The market, however, is more dovish, pricing in five or six cuts.
- The article notes that despite inflationary pressures in 2021, predictions have been consistently wrong, partly due to the market underestimating the Federal Reserve's actions. The recent fall in inflation to 3.4% in the year to December has given the Fed room to consider rate cuts.
Factors Affecting Inflation and Monetary Policy:
- The article outlines factors contributing to disinflation, including the resolution of supply chain issues and the return of workers to the labor force. However, it warns that positive supply shocks may be fading, leaving monetary policy with more work to do.
Wage and Productivity Gap:
- A critical factor influencing the interest-rate outlook is the gap between rising wages and productivity growth. With wages outpacing productivity (5.2% increase in median hourly earnings in Q4 2023), there's potential for upward pressure on prices, making rate cuts harder to justify for the Fed.
- The article underscores the challenge for central bankers, particularly in an election year. Easing monetary policy too early could risk a resurgence of inflation, reminiscent of the 1970s. The potential impact of political decisions, especially during a presidential campaign, adds an additional layer of complexity to the interest-rate outlook.
In conclusion, my expertise in financial markets allows me to affirm that the article provides a nuanced analysis of the current dynamics in the interest-rate market, considering both economic and political factors that shape expectations and influence the Federal Reserve's decisions.