Fed Dilemma

For a long time, the Fed has taken its communication seriously and rightly so. After all, the Fed has to not only handle price stability, but also expectations on inflation. Has Fed lost touch with reality?

Fed sticks to hawkish stance

In the Fed statement on November 01, 2023 and later in the Fed minutes, the Fed has been quite categorical about its stance. It has held on to the view that rates could potentially go up by another 50 bps, although the philosophy now was to maintain the rates at a higher level for a longer period of time. Fed also ruled out any debate on rate cuts, leave along even exploring the merits of the argument. The Fed chair, Jerome Powell, himself appears to veer towards being a hawk, which impacts the stance.

CME Fedwatch begs to differ

Even as the Fed has stuck to its hawkish stand quite steadfastly, there is rapid divergence seen in the CME Fedwatch. This market-based indicator has not only diverged from the Fed stance, but the extent and intensity of divergence is also gathering heft. For instance, the Fed continues to stick to maximum two rate cuts by 2024 stand. However, the CME Fedwatch appears to believe that rate hikes are done and dusted while the Fed could cut rates by as much as 150 to 175 bps by the end of 2024. That is a surprisingly huge divergence; in a battle, where the Fed normally prevails!

Missing on the narrative

What makes the CME Fedwatch so very confident of diverging so substantially from the Fed stance? In the past, the CME Fedwatch had to reconcile with the Fed stance. However, this time around there appears to be greater assurance that the Fed stance is out of sync with the market reality. According to market experts, the Fed has been sticking to a hawkish stance, despite market signals to the contrary. Inflation is secularly down after the Fed did a wonderful job of containing inflation from over 9%. The markets now believe that the Fed must reconcile to the reality that the worst of inflation is over and it must now preoccupy itself with boosting GDP growth. That appears to be missing.

Will the Fed change its stance?

In a sense, the latest divergence looks a lot more convincing in favor of the CME Fedwatch. It does look like the Fed is now sticking to its hawkish stance for longer than required. In the past, the Fed has proven itself to be incredibly fleet-footed and willing to change. It is time for the Fed to seriously take a look at its stance and also its communication to the people. Rate hikes have done the job and from here it is time to put that on hold. With core inflation under check, the Fed does not need to still hold on to its hawkish stance. Flexibility would be a bigger virtue then consistency at the current juncture for the US Fed!