Financial markets are like small children: mercurial, impatient, and often petulant. Today, equity markets and the market for U.S. Treasurys are overly pessimistic about monetary policy by the Federal Reserve and the path of interest rates over the balance of the year. A few months ago, market participants believed that the Federal Reserve would cut interest rates five times this year.
But a series of disappointing reports on inflation, both consumer price inflation and also inflation as measured by the personal consumption expenditure price index, caused the market to ratchet back expectations about interest rate cuts. Now according to data from the Chicago Mercantile Exchange, market expectations are for only one rate cut by year-end. In fact, a minority of traders in U.S. Treasurys believe that the Federal Reserve may raise interest rates one more time.
Federal Reserve Bank of Minneapolis President Neel Kashkari is contributing to concerns that the Federal Reserve could, in fact, raise rates. But Kashkari is not a voting member of the Federal Reserve this year. His comments should not carry much weight. What the market should instead focus on is commentary by the Federal Open Market Committee. The minutes of the meetings of the FOMC are released three weeks after each meeting. The minutes offer concise commentary on the views of the members of the FOMC on the state of the economy and the outlook for interest rates.
The minutes from the most recent meeting of the FOMC, April 30-May 1, indicate that the most recent inflation news has been disappointing. Consequently, monetary policy must remain restrictive. Moving forward, the FOMC will continue to focus on the data. The members of the committee want to see consistent progress toward the Federal Reserve’s 2% core PCE inflation target. On Friday, the FOMC should get data that show that the path to 2% inflation is back on track. Both the market and economists at the Federal Reserve Bank of Cleveland project that after the Friday print for April core PCE inflation, the annual rate of inflation will be running at around 2.74% and at 2.67% after the May PCE inflation data. Progress is being made on inflation.
Importantly, the Federal Reserve projects core inflation only reaching an annual rate of 2.4% by year-end. The market is too impatient. There is a good chance that optimism about interest rate cuts could resume very soon. The Citi Economic Surprise Index just turned negative.
Over the past few weeks, yields on Treasurys have popped back up. Mortgage rates have followed the Treasury market. Mortgage applications have fallen. There has been positive news on wage inflation which will ultimately determine the path of inflation. Wages and prices will converge. The Conference Board believes that the labor market will stall in the second half of this year.
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Households are more pessimistic about the jobs market. Though the government’s data on employment show a resilient labor market, households are at ground zero for the employment market. The economy is slowing. Wage inflation is falling. Energy prices are stable. Low-income households are experiencing financial stress.
The commercial real estate market remains troubled. There are early signs of a deteriorating labor market. Interest rate cuts by the Federal Reserve should occur by September. Moreover, monetary policy is very restrictive; so, the market should soon anticipate two rate cuts by year-end. The Federal Reserve will ensure that nothing “breaks” in the economy.
James Rogan is a former U.S. foreign service officer who later worked in finance and law for 30 years. He writes a daily note.