After a widely expected fourth straight 0.75% interest-rate increase next week, there's a growing view that the Federal Reserve will step down to a 0.50% bump at their December meeting. Even with inflation still going strong, there's value in the Fed becoming more flexible as rates rise to a level restrictive enough to rein in inflation and growth in coming months.
But the response from financial markets this month suggests a lack of confidence that the current expected terminal rate — the level at which the Fed finally stops raising rates — is high enough to finish the job. Even if the economic data cooperates over the next month or two, there's probably at least one more push higher in the probable terminal rate before investors can breathe a sigh of relief.
This raises the question of how the Fed is thinking about the terminal rate. At its September monetary policy meeting, the Fed's projection was that the target federal funds rate would hit 4.6% — a range between 4.50% and 4.75% — in 2023. (The so-called fed funds rate is currently 3.25%.) The hotter-than-expected September consumer price index report has led some Fed officials to talk about getting to that range by the end of this year, which is what markets have currently priced in: a 0.75% increase next week, and then either a 0.50% or 0.75% increase at the December meeting. Markets are signaling they expect one more 0.25% increase in early 2023, taking the terminal rate to a range of 4.75% and 5%.
But if you're the Fed, the market's response to those expectations has been discouraging. Through Monday, the S&P 500 is up 6% on the month (though it's still down 20% for the year, so by itself that shouldn't be an issue for the Fed). More concerning has been the recovery in breakeven rates, which indicate the level of future inflation expected by the bond market.
At the end of September, breakeven rates had fallen to levels seen in the 2010's, suggesting the bond market’s inflation expectations were consistent with the Fed's objectives. That's arguably no longer the case. Through Monday, two-year breakeven rates are up 0.93% on the month, five-year breakevens are up 0.54%, and 10-year breakevens are up 0.43% — and all are now at levels higher than we saw at any point in the 2010's.