LONDON, Dec 14 (Reuters) - The Federal Reserve, investment world and wider economy now have a major sequencing problem.
Even by the Fed's own admission, the full force of its late but brutal credit tightening campaign to rein in decades-high inflation has yet to hit the economy. But inflation and business activity are already slowing faster than many had assumed.
So much so that after Tuesday's news of a second straight month of surprisingly soft U.S. consumer price inflation in November, futures markets are again toying with the idea that Fed rates will be lower at the end of next year than at the end of this one.
With headline annual CPI ebbing to 7.1% last month, and core rates undershooting forecasts too to just 6.0%, most economists seem confident inflation did indeed peak around midyear.
And what's assumed to be the Fed's favourite measure, core inflation readings from the personal consumption expenditures data series, may even have peaked as early as February - even if that's been sticky ever since at more than twice the 2% target.
As impressively, inflation expectations in inflation-protected bond markets show all two, 10 and 30-year gauges hovering around 2.3% - a sliver from Fed targets given that it's now averaging the 2% goal target over time. Equivalent public readings from New York Fed surveys are on the wane too.
Job done? Well, we're now in for another cat-and-mouse game between central bank and price setters in the wider economy and financial markets over how much more the Fed needs to do if the medicine it has dosed so far is already taking effect.
Gauging those amorphous lags in between policy decisions and their effect will likely determine whether the fabled 'soft landing' can be engineered - or whether we end up with policy overkill.
"TAIL SCENARIO"
Sounding something of a klaxon for most asset markets after the CPI number, the peak or terminal Fed funds rate that futures markets implied by May was dragged firmly back below 5%. That suggests the Fed may have half a percentage point or less of hikes left to deliver once it announces a well-flagged half-point rise to the 4.25% to 4.50% range later on Wednesday.
But maybe more important for credit markets looking out over the year ahead and speculators keen to front run the next cycle, implied rates for December/January 2023 to 2024 dipped below those for the same period this year.
That metric is an interesting reflection of what the Fed's been trying to do to prevent markets easing financial conditions on their own accord before the back of the inflation fight was broken and undermining the Fed battle in the process.
In trying to push back against this premature loosening in the late summer, Fed speaker after speaker insisted the job wasn't done yet and that, whatever level rates peaked, there would be no policy easing through next year at least.
In the process, they succeeded in pushing end-2023 rates above end-2022 rates by the end of September and seemed to protest each attempt to reverse that since.
But with yet another downside inflation surprise, the market is knocking on that door yet again - and now awaits any verbal pushback to that on Wednesday with nervous anticipation.
Even assuming the market's correct in assuming the Fed's terminal rate is now back below 5%, there's a half point of rate cuts priced from there by yearend. And 2-year Treasury yields at 4.2% are well below the mid point of the Fed's new expected target band of 4.25% to 4.50% from Wednesday.
Apart from verbal guidance, one important signal markets will watch on Wednesday will be the Fed's economic projections that include policy rate assumptions for the year.
"We suggested that the median 2023 forecast would increase to just below 5% - a 25bp increase - but this (inflation) report increases the downside risks to that prospect," said PIMCO economist Tiffany Wilding, adding she had cut her end-2023 U.S. core CPI inflation forecast to 3.3% from 3.7%.
Notching its deepest inversion in 40 years at some -90bp at one point on Tuesday, the yield curve between 3-month bill rates and 10-year yields - which many think is a warning of recession, disinflation or both - is sending its own pretty clear signal.
For many investors then, the further Fed hikes after this week merely load up the chances of a deep recession more than improve the inflation outlook per se.
If this year's nearly four percentage points of rate hikes hit the wider economic pulse with the assumed 12 to 18 month lag from announcements, that's going hurt through the middle of next year regardless of what comes next.
Like the proverbial ketchup from a well shaken bottle, it may all hit at once.
"The Fed has done a lot of aggressive tightening this year, there is a time lag to see the impact of these measures, and in order to remove risk of over tightening, it's possible the Fed will now look to slow down," Robert Alster, CIO at Close Brothers Asset Management.
The risk that it keeps going and deliberately seeds a downturn on top of unfolding disinflation is cause for concern.
"Lower inflation and negative growth is a tail scenario the market is not pricing yet - this could hurt margins of US companies significantly," reckons Florian Ielpo, head of macro at Lombard Odier Asset Management's multi asset group.
"We have been focusing so much energy on the stagflation scenario that we have forgotten about the good old debt-deflation scenario: this is a risk we cannot afford to ignore."
The opinions expressed here are those of the author, a columnist for Reuters.
Our Standards: The Thomson Reuters Trust Principles.
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December 14, 2022 at 06:00PM
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Column: If Fed sees over the mountain, peak is pure pain - Reuters
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