The Federal Reserve’s recent statements on interest rates have been consistently reinforcing the narrative of “higher for longer.” Fed officials assert that it will be necessary to further raise rates and maintain them at a restrictive level in order to achieve the Fed’s 2% inflation target in a timely manner.
However, given the current economic conditions, with the likelihood of a recession, weakening consumer activity, and already tamed inflation, can we really rely on the Fed’s projections and expect rate hikes? And even if rates do start to come down, will it be a slow, multi-year process as the Fed suggests?
This is where we need to question the reliability of the Fed’s forward guidance, which is the tool they use to influence market behavior. The Fed’s ability to shape market expectations through public statements is a powerful tool, as former Fed Chairman Ben Bernanke once stated, “monetary policy is 98 percent talk and only two percent action.”
But let’s examine the historical accuracy of the Fed’s forward guidance. The Fed’s “dot plot,” which provides the future projections of the Fed Funds Rate by each voting member of the FOMC, has often proven to be inaccurate. Looking back over the past decade, the dot plot consistently projected a faster rise in rates than what actually occurred.
In addition, the 2-year Treasury yield, considered a reliable predictor of Fed rate movements, has often been more accurate in forecasting rate changes than the Fed itself. Currently, the 2-year Treasury yield is rising, indicating that rate cuts may be on the horizon, contrary to the Fed’s hawkish stance.
It’s important to note that throughout history, when the Fed has started cutting rates, it has typically done so in a sharp and steep manner, rather than a slow and gradual process. And every recession has been accompanied by a temporary drop in the Fed Funds Rate.
Given the Fed’s track record of failed predictions and the bond market’s different expectations, it’s prudent to question the Fed’s reliability. As investors and traders, we should focus on analyzing the data rather than relying solely on the Fed’s statements. The bond market, particularly the 2-year Treasury yield, provides valuable insights into future rate movements.
As for inflation, it has already been tamed, and the data will eventually reflect this. The shelter component of core inflation, which comprises approximately 40% of the index, lags behind real-time changes in housing costs. Therefore, while shelter CPI still shows a year-over-year gain, the actual rent rates and home prices indicate a different story.
Looking ahead, we believe that interest rates will fall sooner, faster, and further than what is currently anticipated by the market. The market’s trust in the Fed’s “higher for longer” narrative may be misguided, similar to a child being repeatedly amazed by a simple magic trick. Rate-sensitive sectors like REITs and Utilities present attractive opportunities in light of this potential rate decline.
Ultimately, we must remember the famous line from Sir John Templeton: “The most dangerous words in investing are, ‘This time it’s different.'” While each situation may present unique circumstances, the pattern of interest rates remains consistent. We should base our decisions on what the data reveals rather than blindly trusting the Fed’s predictions.
So, can we trust the Fed’s “higher for longer” narrative? Based on historical accuracy and the bond market’s signals, it’s clear that skepticism is warranted.