In a significant departure from market expectations, U.S. central bankers indicated on Monday that they foresee interest rates remaining high and potentially increasing further due to persistent inflation. This contrasts with the prevailing belief that the Federal Reserve would start cutting rates before the end of 2023.
Following the Fed's recent raise of its benchmark overnight interest rate to a range of 5.00%-5.25%, Atlanta Fed President Raphael Bostic emphasized the need to adopt a cautious approach. He stated that the appropriate policy stance is to observe how the economy responds to the recent policy actions before making any further adjustments.
While there has been some moderation in inflation, Bostic believes it will not cool down quickly enough to warrant rate cuts in the near term. In fact, he expressed a bias toward further rate increases rather than cuts if the need for action arises.
Minneapolis Fed President Neel Kashkari echoed Bostic's sentiment, highlighting the Fed's ongoing efforts to bring inflation back down. Despite a slight decrease in April, with the Consumer Price Index showing a 4.9% annual pace compared to 5% in March, Kashkari emphasized that inflation remains unacceptably high. Additionally, the labor market, with an unemployment rate of 3.4%, remains strong.
Chicago Fed President Austan Goolsbee disclosed that his vote in favor of the recent rate hike in May was a close call due to concerns over tightening credit conditions following recent bank failures. He acknowledged that the full impact of the Fed's rate hikes has yet to be fully realized. Goolsbee emphasized the importance of ensuring inflation returns to its target path without triggering a recession.
However, Goolsbee also issued a warning, citing the case of Silicon Valley Bank, which ceased hedging against higher rates based on market expectations of a reversal in the Fed's rate-hike policy. Mismanagement of interest-rate risk contributed significantly to the collapse of the Santa Clara-based lender in March.
Despite the Fed officials' stance on high interest rates, financial markets are pricing in a low probability of another rate hike at the Fed's upcoming policy meeting in June. Interest rate futures contracts indicate expectations for the policy rate to end the year in the 4.25%-4.50% range.
It is possible that market pricing reflects hedging against a more severe recession than commonly anticipated. Bostic noted that any recession would likely be neither prolonged nor severe. Additionally, markets may be anticipating a swift decline in inflation.
Jan Hatzius, Chief Economist at Goldman Sachs, cautioned that market pricing is overly optimistic in anticipating a lower federal funds rate over time. He emphasized that the economy continues to expand even as inflation subsides.
The firm stance of Fed officials on high interest rates amid concerns over inflation indicates a potential divergence between market expectations and the central bank's intended path. The outlook for interest rates and inflation will continue to be closely monitored as the economy evolves.
