Market Reacts to Consumer Price Report

Bonds and stocks experienced a temporary shock on Tuesday following a consumer price report that surpassed market expectations. As a result, the federal-funds futures market significantly adjusted its pricing of Federal Reserve interest-rate cuts for the year. The current target range of 5.25% to 5.5% now anticipates around three rate cuts of 25 basis points each. (Note: A basis point equals one-hundredth of a percentage point.)

Recent Market Repositioning

The market's shift aligns closely with the most recent Summary of Economic Projections from the December Federal Open Market Committee meeting. This projection indicated a median fed-funds rate expectation of 4.6% by the end of 2024. Surprisingly, as late as January, the futures market suggested at least six 25-basis-point cuts by December.

Potential Scenarios

Speculations range from assuming multiple rate cuts to foreseeing no Fed rate cuts in 2024. Past forecasts, such as Bloomberg Economics predicting a 100% chance of a recession in 2023 back in October 2022, have often proved inaccurate.

Deutsche Bank's Insights

Deutsche Bank's U.S. economics team, under the leadership of Matthew Luzzetti, has proposed two alternative scenarios. In a recent research note, they suggest that the Fed might maintain current interest rates throughout 2024. While this isn't their primary prediction, which anticipates four 25-basis-point cuts beginning in June, they acknowledge that the likelihood of the Fed keeping rates steady may not be insignificant.

Deutsche Bank's Alternative Scenarios Contradict FOMC's Projections

In analyzing the Federal Open Market Committee's (FOMC) median scenarios, Deutsche Bank economists have presented two "hawkish" alternatives that challenge the committee's projections.

The first alternative scenario suggests a slightly lower unemployment rate of 4% in December 2024, compared to the FOMC's projection of 4.1%. Additionally, this scenario predicts less progress in slowing inflation, with the "core" personal consumption-expenditures index running at a 2.7% annual rate, rather than the FOMC's forecast of 2.4%.

Furthermore, these economists consider two different estimates for R-star, which represents the neutral fed-funds rate adjusted for inflation. The first alternative scenario assumes an unchanged R-star of 0.5%, while the more hawkish scenario assumes an R-star of 1.5%.

According to Deutsche Bank, the first hawkish scenario suggests a reduction of the fed-funds rate by 65 basis points this year. This is 20 basis points less than the FOMC median projection. On the other hand, the second hawkish scenario implies less than 20 basis points of cuts or essentially no reductions this year.

It is worth noting that historical patterns show the market often anticipates a shift in Fed policy before it actually happens. For instance, after the financial crisis of 2008-09, the market was consistently early in anticipating the liftoff in the fed-funds rate. The initial hike didn't occur until December 2015, which highlights the possibility of premature market expectations for a pivot in Fed policy once again.

While these alternative scenarios offer a contrarian view, they serve to challenge and potentially reshape prevailing projections put forth by the FOMC.