Markets are ahead of the Fed on rate hikes

The bond market went wild on Thursday, pushing interest rates up. But the market seems to have gotten ahead of itself.

Why is this important: The extraordinary rise in rates makes sense if you think the Federal Reserve is going to react to slightly higher-than-expected January inflation numbers with a sense of panic. But that’s not the pattern that central bank leaders, and in particular Chairman Jerome Powell, have displayed throughout the past year – so the shift in expectations seems overdone.

  • Fed policymakers are all but certain to raise the target interest rate next month, but it’s still uncertain whether they will act as aggressively as markets now expect – and unlikely. ‘they act before their regular meeting, as some market chatter discussed Thursday.

State of play: The yield on two-year Treasury securities rose 0.24 percentage points on Thursday, to 1.58%. Futures markets are now pricing in the virtual certainty that the Fed will raise rates by half a percentage point next month, which would be the first such action in two decades.

  • The swing was initially driven by a Consumer Price Index report for January showing inflation at 0.6%, above the 0.4% expected, and the highest number in a year on the other (7.5%) in four decades.
  • Later in the day, James Bullard, president of the Federal Reserve Bank of St. Louis, told Bloomberg that he favored a half-percent rate hike at the March meeting and a full percentage point by July.

The big picture: It is true that the high inflation figure is leaning the Fed towards more aggressive monetary tightening. But that wasn’t so far from expectations that Fed leaders would be likely to throw away their playbook as drastically as market moves suggest.

  • Bullard has a vote on monetary policy this year, but historically his policy views have been more responsive to the latest data points than the typical Fed official, and certainly more so than Powell and other top leaders.
  • Inflation figures exceeding expectations by two tenths of a percentage point for a single month are not enough to drastically change these opinions.

Powell and his colleagues pushed for higher rates in a gradual, step-by-step process, keeping options open and aiming to tighten financial conditions without breaking the economy.

  • They are more likely to be open to large and steep interest rate hikes only after the rate hike campaign begins and it is clearer whether inflationary pressures are easing or not.

The bottom line: Fed leaders are loath to appear panicked and believe that too abrupt action could introduce unnecessary volatility into markets and the economy. Based on that mindset, a single month’s CPI reading won’t be enough to drastically change the policy trajectory – even if it created a hairy day in the markets.