The recent announcement from the NY Fed’s meeting raised expectations for a rate hike in the coming months, but that does not mean that it will lead to a rate increase. The Federal Reserve has an explicit mandate to promote price stability and maximum sustainable employment. As such, it aims to anchor inflation expectations at 2 percent on average. In the 2010s, the Fed was concerned about inflation falling below this target. However, the data showed that prices have been rising too rapidly.
While price gains in October were tempered to 7.7 percent, it remains high, making it uncomfortably high for many consumers. The rate is still above the 2 percent target set by the Fed. The central bank plans to keep raising interest rates for a while, hoping that the economy will slow. Higher interest rates make borrowing more expensive and reduce demand.
Inflation expectations are closely related to interest rates. They measure how much people expect prices to rise, and if that rate falls too far, the economy could see a deflationary spiral. If inflation expectations are too low, the Fed will be unable to cut rates and stimulate the economy.
On the other hand, after the October inflation report came out, the U.S. Treasury yields rose. The report showed that headline prices rose by 7.7% year-over-year, but declined by 0.2 percentage points since 2021. Core prices remained high at 6.3% year-over-year, which is still very high by historical standards. In response, the market priced a more moderate policy path for the Fed. In fact, the market priced out the entire hike in 2023 – which caused two-year and 10-year yields to fall by 33bps and 35bps.
A rising dollar is bad news for companies that do business overseas. It decreases their sales abroad in real terms. Several companies have already warned about the negative effects of the rising dollar on their bottom line. Nonetheless, the financial sector tends to do well after rate hikes. Bank stocks, as well as corporate bonds, tend to do well during times of rising rates.
Meanwhile, the US Consumer Price Index continues to slow, announcing that the median annual increase in the Consumer Price Index was 7.7 percent, down from 8.2 percent in August. The decline in health insurance has slowed down the pace of growth in total PCE, which is a key component of the inflation measure. Despite this decline, the risk for inflation remains high, with resilient consumer demand and a solid labor market. The big question for the market is what happens to prices outside of the housing sector.
Market participants have generally expected the Federal Funds Rate to rise further through the end of this year. However, after that, the policy rate will reach its peak, which is expected to be in the first half of 2023. After 2023, the market implied path of the federal funds rate will likely slope downward, indicating downside risks to the policy rate path. A median respondent to an Open Market Desk survey indicated that policy rate hike expectations would remain flat through 2023, while a median respondent assigned a probability that real GDP would decline in that year.