The Dumbest thing Powell Could Do

While forward curves and market participants widely expect policy rates to peak around the end of 2023 and begin to decline thereafter, history suggests that they’re probably wrong.

The chart below shows the history of rate predications (thin lines) against actual rates. As you can see, forecasts are wrong almost 100% of the time. In reality, it is equally probably that rates fall, rise or remain the same. The market (as reflected by forward curves) is not a good predictor for the future.

Chart Source: Chatham Financial

Instead of trying to predict interest rates, investors should prepare for several eventualities. For example:

1. Disinflation remains persistent and becomes deflationary. Recession begins. Fed cuts rates aggressively.

2. Disinflation stalls and inflation remains sticky. Recession begins. Fed holds.

3. Disinflation stalls and inflation rises again. No recession. Fed raises.

4. Etc.

Make up your own scenario. There are hundreds of combinations.

Here’s my point: be prepared to be wrong.

Now here are the current realities:

• Aggregate employment data remains strong.

• Growth in average hourly wages remains in inflationary territory.

• Commodity prices have rallied.

• Housing prices have remained resilient and have picked up in some areas.

• Equity markets are near all time highs.

The market and economy has remained resilient in the face of higher rates, giving the Fed more room to remain restrictive.

I think Powell’s biggest worry right now is that he loses his tenuous grip on inflation. He’s had some success, with inflation halved over the past several months. However, several boxes remain unchecked to clearly suggest the inflation war is won (as you can see with the facts above).

Powell is unlikely to loosen his grip until most or all of the above facts move in the opposite direction. That means higher-for-longer.

Of course, Powell is only human and humans do stupid things. The dumbest thing he could do right now is prematurely declare victory. If Powell adopts a dovish tone and the market sniffs that inflation is resurging, we could see a repeat of 2022 (decline in both stocks and bonds). I think the probability Powell does this is low.