Investors would be better off believing the Fed

Try as it might, the Federal Reserve can't seem to break the market's relative optimism about the outlook for interest rates. But there's one thing investors need to understand: The central bank has ample power to make its predictions come true.

The message from last week's policy-making meeting was almost entirely hawkish. The Fed's statement retained the language of "ongoing increases," suggesting several more interest-rate hikes. Officials projected a higher-than-expected peak rate of at least 5% to 5.25% (with greater unanimity), higher inflation for longer, lower output growth and higher unemployment.

Chair Jerome Powell went further, hinting that the Fed might have to take rates higher for longer if financial conditions don't remain sufficiently tight. He discounted reports of decelerating inflation, noting that while it was gratifying to see less price pressure in the goods market, the key was what happened to services (excluding housing). He said he wanted to see considerably more slack in the labor market than was yet evident. 

The only dovish tilt was Powell's response to a question about whether the Fed would downshift to a smaller, 25-basis-point rate hike at its next policy-making meeting in February.  He didn't answer the question directly, but he did endorse the logic of going more slowly, giving the central bank more time to assess the economy's response to previous tightening.  As Powell put it, speed is now much less important that the destination.  

Yet despite the Fed's clear warnings of more tightening to come, investors aren't getting the message. Futures markets still suggest a peak federal funds rate of less than 5%, about 20 basis points lower than the Fed's projections, with rate cuts beginning next summer. 

Why the skepticism? I see a couple possible explanations. 

First, perhaps markets doubt the Fed's resolve, and expect it to capitulate as soon as the unemployment rate moves higher. If so, they're wrong. Powell knows that failing to push inflation back down close to 2% would likely allow expectations to become unanchored, requiring the Fed to respond even more forcibly later. He doesn't want to repeat the mistakes of Arthur Burns. The entire policy-making Federal Open Market Committee seems united on this point, with no participants anticipating rate cuts in 2023. 

Second, maybe market participants expect economic growth to be slower and inflation to moderate more quickly. This seems more likely: People seem to be paying more attention to improvements in headline inflation than to labor-market tightness.

Whatever market participants might think, they need to recognize that the Fed is in control. It has the power to achieve whatever financial conditions it needs to slow growth, push up the unemployment rate and bring down inflation. If markets don't come along willingly, it will force them.

What will be needed remains highly uncertain. Just a year ago, Fed officials expected the federal funds rate to be below 1% right now. The forecast for next year could be no less mistaken, so humility is in order.

This business cycle is highly unusual, in some positive ways: Household and business balance sheets are in very good shape, and there's little risk of a financial cataclysm like what happened in 2008. It's reassuring that, amid the most rapid rise in short-term rates since the early 1980s, the only significant financial blowups have occurred in crypto, with little to no contagion.

The unique economic background also means that the Fed holds unusual sway. It can induce a recession (as seems likely), but output should rebound relatively quickly when the central bank decides that its inflation-fighting job is done. With short-term rates likely to peak above 5%, it will have plenty of ammunition to support the recovery.

This may help explain the performance of the US stock market, which is well above the lows it reached earlier this year. Investors seem to be anticipating the recovery following the downturn. Unfortunately, this optimism has a downside: It means that the Fed will have to work harder, tightening monetary policy more than it otherwise would, to achieve its 2% inflation objective.

Bill Dudley, a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics, is a senior research scholar at Princeton University's Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.