The confluence of events over the past couple of weeks has caused a reset of investor expectations regarding what and when the Federal Reserve’s next move will be.
Currently the market is pricing in one 25 basis-point rate hike next March in contrast to what were until recently fairly solid expectations of at least one rate cut by the end of this year.
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A rate increase will depend upon the lagged impact of the supply shock caused by the war, how long it will take to repair the damage to energy production in the Persian Gulf, where oil prices end up, and the durability of the memorandum of understanding that the United States and Iran signed.
Inflation as measured by the personal consumption expenditures index, the Fed’s preferred gauge, stands above the central bank’s 2% target while the recent consumer price index and producer price index both imply rising costs.
In light of the elevated prices, keeping rates where they are is the most appropriate policy action at this time.
Just as important, inflation was moving higher before the war because of rising goods prices in addition to sticky service prices.
We think it will take some time to push inflation back down below 3%, which will be reflected in the Federal Open Market Committee’s dot plot and Summary of Economic Projections to be published this afternoon.
The FOMC will remove the easing bias in its statement, and we think that investors should proceed with caution on assuming how fast and how far top-line inflation growth will slow should the memorandum of understanding prove durable.
