The interest The market has a dirty secret, which practitioners call “the hairy card.” Its most important organ 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 that show the future path for interest rates that the market, as a whole, expects at any point in time. The graph leaves two thoughts. The first is that someone 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 terrible at predicting where interest rates will go.
Since inflation started rising in 2021, these predictions have been largely wrong in the same direction. They have either underestimated the Fed’s willingness to raise rates or overestimated how quickly the Fed will start lowering them. So what about the fact that the interest rate market is once again pricing in rapid monetary policy easing?
This time it’s different, and in an important way. A year ago, investors who expected interest rates to be cut soon fought the Fed, whose rate setters had no such intention. Then, in December, the central bank reversed course. Interest rate cuts are now being discussed, chairman Jerome Powell announced, with officials predicting three of them (or a value of 0.75 percentage points) in 2024. The market has gone even further and priced in five or six before the year is out. However, she is now moving with the Fed, rather than against it. Mr. Powell, in turn, is free to make dove noises because inflation has fallen sharply. Consumer prices rose just 3.4% in the year to December, compared with 6.5% the year before.
Yet recent years have shown how eager investors are to believe that cuts are coming, and how often they have been wrong. And so it is worth considering whether they will make the same mistake again. It turns out that a world in which interest rates remain high for longer is still all too easy to imagine.
Start with the causes of disinflation so far. There is little doubt that rapidly rising interest rates played a role, but the fading of the supply shocks that drove up prices in the first place was probably more important. Tangled supply chains were untangled, locked-down workers rejoined the workforce, and rising energy prices came crashing back to earth. In other words, negative supply shocks gave way to positive ones, causing inflation to cool even as economic growth recovered.
Yet these positive shocks are now themselves fading. Once supply chains are untangled, they cannot become so again. The US employment rate – the population’s share of the labor force – rose from 60% in April 2020 to 63% in August last year, but has not increased since. Meanwhile, energy prices stopped falling early last year. And escalating violence in the Middle East, where America and Israel risk growing conflict with allies and associates of oil-producing Iran, could still cause prices to rise again. All this means that monetary policy has even more work to do if inflation is to continue to fall.
While the US employment rate has stopped rising, wages have continued to rise. According to the Atlanta Fed, average hourly wages were 5.2% higher in the fourth quarter of 2023 than a year earlier. Adjusted for inflation, this is well above the long-term annual growth rate of worker productivity, which has been just over 1% since the 2007-2009 global financial crisis. A gap between wage and productivity growth will, all else being equal, continue to push up prices. For the Fed, this makes rate cuts more difficult to justify.
The case that interest rates could remain high is therefore plausible, even if you ignore the political background. In an election year, that is a luxury that central bankers do not have. The danger of easing monetary policy too early and a return of inflation, as happened in the 1970s, is already looming over the Fed. During a presidential campaign with Donald Trump, cutting interest rates too quickly could have even more serious consequences. There would inevitably be calls that officials had abandoned their mandates in an effort to undermine the economy, appease voters and keep Mr. Trump out of office.
And Mr. Trump could well win, in which case he will likely pursue deficit-financed tax cuts, which will further increase inflationary pressures and force the Fed to raise rates. Such a scenario is still pretty much speculative fiction. It’s certainly not what investors expect. But when you look at their predictive performance, that’s hardly any consolation.■
Correction (January 25, 2024): An earlier version of this article incorrectly suggested that consumer prices rose 6.5% in the month before December. In the period up to and including December 2022, they even increased by 6.5%. Sorry.
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Also: how the Buttonwood column got its name