Market-Fed Alignment Is Welcome, But Not Enough

For the first time in quite a while, there is an alignment between what the Federal Reserve is signaling about its interest-rate setting this year and what the markets think will happen. More importantly, this has occurred without major disruptions to the economy and markets. Yet, underpinning it all, is an assumption about policy behavior that has neither been fully endorsed by the Fed nor sufficiently internalized by markets.

After diverging quite substantially for an unusually long time, markets have adjusted their implicit pricing for 2024 Federal Reserve rate cuts from the six to seven they expected at the end of last year to just two to three on the eve of this week’s policy meeting. This expectation is consistent with what the Fed has been flagging and is likely to be validated by the “dot plot” that will be published after Wednesday’s gathering.

This market-Fed alignment, which has entailed higher market yields across maturities, has occurred with remarkably little damage to stocks and the economy. The major US equity indices are still hovering around all-time highs. The economy, while showing some areas of slight weakness, remains robust overall. It’s performing significantly better than most other advanced countries and, compared to a year ago, very few expect it to fall into recession any time soon.

All this makes sense, provided it is accompanied by a nuanced understanding of what the Fed will be willing to do (and, in my opinion, should do for overall economic well-being).

It has become increasingly clear in recent weeks that the Fed faces challenges in the “last mile” to attaining its 2% inflation target. The first stage of this journey saw headline CPI inflation, the measure most widely followed by the general population, drop from over 9% in June 2022 to just above 3% in recent months. It was driven not just by lower price increases but also outright falls in goods that overwhelmed stubbornness in services. Also, with energy deflation playing an important role, the decline in core CPI inflation was more timid.