The big risk in Wall Street’s interest rate bet

If market expectations of another significant rate hike in the near term are confirmed, the Fed would likely end up raising the top end of its target range by just 25 basis points at its next meeting later this month. That would keep alive the market’s thesis that US interest rates will fall in the second half of the year.

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If the data disappoints and shows higher-than-expected inflation, the meeting is likely to raise the federal funds rate by 50 basis points. The Fed’s view that the federal funds rate will hover above 5 percent and still be there at the end of the year is bolstered.

That wouldn’t be good news for investors, as the opposite sentiment is already priced into stocks, bonds, and other risky assets.

Of course, the results do not only relate to the financial markets. The Fed seems convinced that it will take a significant rise in unemployment and inevitably a recession to drive inflation out of the economy. The markets are convinced that a recession is inevitable.

The risk is in killing too much. The Fed got it wrong about the trajectory of inflation when it was on the way up, mistakenly believing it would be “temporary”.

Given the lag between monetary policy decisions and their real impact, it could just as easily be wrong about the pace at which inflation is falling, plunging the US into an unnecessarily deep recession rather than the ‘soft landing’ of which the financial markets still think is possible.

There are Fed officials who believe that while the Fed might not necessarily change its expectation of the “final rate” — the top interest rate this cycle — it could use smaller increments (e.g., 25 basis points or less instead of 50 basis points). gain more time to assess the impact of his decisions.

A result on Thursday night in line with markets’ expectations would make the Fed more likely to pursue this strategy and reduce the risk of exaggeration.

More pessimistic would argue that if the Fed isn’t vigorous enough earlier this year, it could lay the groundwork for another surge in inflation that would undo much of the effort already made and inflict even more pain on US households and businesses.

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The dominance of US markets in global markets, the importance of the US economy and the US dollar within the global economy, and the influence of the Fed’s rate setting on other central banks and their policies mean that its decisions and outcomes impact economies have , individuals and businesses well beyond US borders.

Last year the Fed had the relatively straightforward task of raising US interest rates until inflation stopped rising and inflation started falling again, which it did.

The task is far more complicated this year, as the Fed must make the more difficult judgment of how much of an hike is enough and when that moment should come to ensure inflation falls within its target range over time. The consequences of a misjudgment in either direction would be severe.

https://www.smh.com.au/business/markets/the-big-risk-in-wall-street-s-bet-on-interest-rates-20230112-p5cbzt.html?ref=rss&utm_medium=rss&utm_source=rss_business The big risk in Wall Street’s interest rate bet

Brian Lowry

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