Fed funds futures are now progressively pointing to rate reduction from the U.S. central bank, according to Tim Duy, chief U.S. economist at SGH Macro Advisors.
According to the CME’s Fedwatch tool, the likelihood of a Fed rate cut in May has increased from 14% last week to 60% presently. By the end of the year, it is anticipated that the Fed will lower interest rates to 3%.
The bond most susceptible to changes in monetary policy, the 2-year Treasury BX:TMUBMUSD02Y, saw its yields drop 8 basis points to 3.59%. In contrast to prices, yields move in the other way.
“We anticipated Powell would lean hawkish Friday, but he went a step further even as equities were crashing, and market participants may have missed a key insight, scary as it might be,” Duy adds.
Powell described inflation expectations using new terminology. He noted on Friday that inflation estimates covering more than a year were starting to raise concerns.
More importantly, his advice shifted to one that was more forward-looking. “If the economy remains strong but inflation does not continue to move sustainably toward 2%, we can maintain policy restraint for longer,” Powell said, eliminating two phrases that were used to prevent rate hikes. In words he did not repeat, the central banker stated on March 7 that “we can ease policy accordingly if the labor market were to weaken unexpectedly or if inflation were to fall more quickly than anticipated.”
According to Duy, change is crucial. “Hikes are no longer specifically mentioned, but they are also no longer specifically excluded. When Powell made this adjustment, he was aware that markets were plunging. It’s not tone deafness. That’s intentional,” Duy explains.
Additionally, Powell instructed market players to understand the ramifications when the Fed’s mandate’s two components—inflation and jobs—are threatened from separate angles. “The higher and more persistent spot inflation and inflation forecasts, the higher and more persistent spot unemployment and unemployment forecasts need to be to hold rates steady,” Duy states.
The Taylor Rule, a rules-based approach to interest-rate policy, was used by Duy to calculate the trade-off on his own.
Duy references monthly changes in the core personal consumption expenditure price index. “Now, if you are penciling in 0.4s, 0.5s, or maybe in some cases 0.6s for core-PCE in the coming months, think about how quickly and disastrously the labor market outlook needs to turn to support a rate cut,” he says. “After all, 0.5 is more than 6% annualized.”
