When you constantly threaten a "higher for longer" interest rate, at a level that's already historically very tight, and you attribute that stance to a persistently higher than desired inflation rate, the market starts believing you — on both fronts (the interest rate and the inflation rate).
On the former, due to the Fed's hawkish rhetoric of the past few months, the market has reduced its expectations on rate cuts this year by more than 125 basis points (i.e. pricing in a higher interest rate for longer).
On the latter, the Fed's hawkish rhetoric may have also influenced inflation expectations, higher (higher inflation rate for longer)!
We've had two consumer surveys on inflation expectations reported over the past two trading days, and both jumped higher.
As we've discussed in the past, what the Fed fears more than inflation itself, is losing control of inflation expectations (consumer and business).
When people lose confidence in the Fed to stabilize prices, behaviors change – and we can get one of two scenarios.
Scenario 1: Expectations of higher prices, can lead to consumer and business behaviors that lead to higher prices (pulling forward purchases, leading to higher inflation).
However, in the current case, a spike in inflation expectations was accompanied by a plunge in sentiment.
With that, we can get the opposite outcome for behaviors, and prices …
Scenario 2: A plunge in sentiment, due to high prices can lead to a plunge in spending. Things become unaffordable, and people stop spending. High prices can cure high prices.
But that puts the economy at a significant risk of a downturn, and suddenly deflation can become the greater risk.
With all of this in mind, we had a similar dynamic in November of last year.
The University of Michigan survey on the expectations for price changes over the next five years spiked to around 12-year highs (of 3.2%). And sentiment was in a multi-month plunge.
What did the Fed do? Did they posture for more tightening?
No.
They signaled the end of the tightening cycle.
