HOPING FOR RATE CUTS? MARKETS AREN´T DONE WITH HIGH INFLATION JUST YET. / BARRON´S MAGAZINE

Hoping for Rate Cuts? Markets Aren’t Done With High Inflation Just Yet.

By Dana M. Peterson

ILLUSTRATION BY MARK PERNICE

Long-dated U.S. Treasury yields have surged in recent weeks. 

The cause: term-premium risk, steady downsizing of the Federal Reserve’s balance sheet, and of course, expectations for elevated interest rates.

But “higher-for-longer” rates reflect a darker truth that markets may not have priced in.

Markets may be interpreting higher-for-longer as an extended pause before the Federal Open Market Committee begins cutting interest rates. 

Typically, the period between the Fed stopping a hiking cycle and starting to ease rates is three to six months.

Consumer price index data for October show inflation cooling. 

Market expectations for a rate cut at the Fed’s March meeting—just four months away—immediately rose by 20 percentage points, according to the CME FedWatch Tool.

The Fed’s September Summary of Economic Projections doesn’t anticipate key inflation gauges returning to the 2% target until 2025, so the Fed may wait longer than usual before cutting. Our forecast at the Conference Board, for example, doesn’t envision rate cuts until mid-2024—eight months from now.

Markets might also be anticipating a slow easing. 

The SEP signals only 50 basis points of interest-rate cuts in 2024. 

(A basis point is 1/100th of a percentage point.) 

Moreover, investors may expect the federal-funds rate will remain elevated relative to historical norms over the next few years. 

The SEP suggests another 125 basis points of cuts in 2025 and 100 in 2026, leaving the federal-funds rate at 2.75% to 3% by the end of 2026—notably higher than the 1.5% average federal-funds rate over the past 20 years.

These interpretations of higher-for-longer interest rates are all correct, but they potentially miss one important factor underpinning the need to keep the federal-funds rate above recent levels: “higher for longer” inflation. 

If persistent inflationary drivers have their way, then even the FOMC’s 2.5% long-term federal-funds rate estimate may be too low.

Higher-for-longer inflation could mean that supply-side forces, including food or energy prices or higher wages due to labor shortages, perpetually keep inflation above target. 

This might force the Fed to maintain a tight monetary policy stance to push key inflation gauges back down to target. 

Higher-for-longer inflation also refers to upward price pressures that cause the Fed to keep interest rates high to sustain a 2% target, a policy we don’t anticipate the central bank will alter for risk of losing credibility and sparking a surge in inflation expectations.

Structural changes in the U.S. and global economies will cause inflation to be higher for longer, perhaps for decades. 

That’s true despite the recent slowing in the rate of inflation. 

Given this prospect, the federal-funds rate will need to be higher than what markets and policy makers seem to expect.

A growing number of long-term drivers of upward inflation pressures suggest that interest rates will remain elevated over the next few years and perhaps even for the foreseeable future.

Labor shortages are here to stay as millions of baby boomers retire, depriving the labor market of some of its most skilled workers. 

This trend will intensify over the next decade, bloating wages as companies scramble to attract and retain talent.

Meanwhile, roughly 155 million millennials and Generation Zers will reach peak homebuying age over the next 20 years. 

This outsize demand, combined with a limited supply of new homes (due to underinvestment), and existing homes (due to elevated mortgage rates), points to home-price and rent inflation.

Deglobalization is highly inflationary. 

It will be accelerated by companies seeking supply-chain resiliency and U.S. industrial policy compliance. 

Dismantling far-flung supply chains and reshoring, onshoring, and friend-shoring are tremendously expensive. 

New facilities and higher wages cost money. 

Industrial policies are also linked to national security concerns. 

The U.S. is vulnerable to disruptions in global supply chains for rare earths and high-tech equipment like semiconductors. 

Supply-chain disruptions were a key inflation driver during the worst of the pandemic.

Renewable energy should help reduce environmental hazards and save money, but the road to a greener economy is lengthy and costly. 

The transition will require massive investments in infrastructure, equipment, and retrofitting, as well as upskilling and reskilling workers, and could last for years. 

Additionally, the government spending necessary to achieve that transition will add to an already ballooning federal debt share of GDP. 

Outsize sovereign debt can lead to ratings downgrades, a higher cost of raising funds to finance the debt, and crowding out private investments, which also raises the cost of capital for private ventures.

Productivity gains and automation, including artificial intelligence, may help offset some of these upward inflation pressures, but they may not be enough. 

Indeed, it may be up to the Fed to keep rates higher for the foreseeable future to resist persistent, pernicious inflation. 

So, markets should strap in for a future of higher yields, rising capital costs, lower consumption and investment, expanding debt service on national debt, and ultimately slower U.S. GDP growth.