Partner, Head of Fixed Income
The Federal Open Market Committee (FOMC) met on Jan. 31 and as expected kept interest rates unchanged. However, Chair Powell threw a bucket of cold water on the bond market’s expectations for a March cut in the fed funds rate, calling it “not the most likely case.” He reiterated the Committee’s view that inflation remains too high and that they will keep rates higher as a result until the data suggests otherwise.
Although markets were taken aback by the more hawkish tone, we viewed it as appropriate given the inflation data and to counter the overreaction to the December meeting. We viewed that rally as markets getting way ahead of themselves and being overly optimistic. Powell's hawkish comments were understandable if he too believed that he was misinterpreted at the December meeting and therefore needed to correct the situation. He needed to bring down the market’s expectations and he succeeded.
While we were not necessarily surprised by his tone, we were surprised that the Committee did not provide more details on the expected balance sheet reduction. Chair Powell has stated that the next move on rates will be a cut, the timing of which is less certain, but nonetheless a cut. Should the Fed continue to reduce balance sheet assets and cut rates at the same time, then this would send a conflicting message. The former is restrictive, and the latter is accommodative. They should have taken the opportunity during the January meeting to spell out their intentions. The Fed has strived for more transparency to lessen potential volatility, and they dropped the ball on this again.
Now that the market has had time to digest Powell’s comments, what is its expectation for the fed funds rate in the coming months?
To no one’s surprise, a March move is off the table, with a cut now slated for the May 1 meeting. Even after this meeting’s fireworks, the Fed and markets are still not in sync. The markets are pricing in a year-end fed funds rate of just under 4%, while the most recent Fed dot plot shows the Fed members’ median forecast at 4.625%. This suggests that the markets are still too optimistic. As long as this disagreement exists, the potential for market volatility will remain elevated.
Taken as a whole, Powell’s hawkish tone along with the lack of communication about the balance sheet and difference in rate expectations leads us to conclude that the Fed is much more concerned about inflation than the market, which holds a more positive view. The data will eventually show who is correct but given the January employment numbers, which reflected very strong unexpected jobs gains, the Fed’s cautiousness is warranted—for now. But that does not mean the path forward will be smooth, as yield movements since the FOMC meeting have shown. We do expect more market volatility in the coming weeks and months as each important data release is met with heightened apprehension.
