The markets are pricing in less hiking than FOMC members feel is appropriate in the dot plots.
The well-rehearsed arguments, that the Fed predicts what it sees as its most likely path and that market pricing is an average of many scenarios, are only part of the explanation.
We believe the market is putting too much weight on foreign developments when assessing growth and US inflation.
We also believe that the markets badly misinterpret the Fed’s reaction function, which is odd, as Chair Yellen explained it in 2012. Maybe it was lost in translation.
Markets seem to be extrapolating into the future the Fed’s behaviour in recent years, where rates did not respond to data. Actions speak louder than words.
The Fed’s abandoning the unemployment threshold was a missed opportunity to tell the market about the Fed’s non-linear reaction function.
The market puts too little weight on unemployment in predicting Fed rate moves. The market may also be putting too much weight on short-run moves in inflation.
With the jobless rate virtually on top of the point where the Fed considers the NAIRU to be, we think the Fed is substantially behind the curve, by even more than it originally intended.
The Fed will need to put the market straight or risk getting even further behind, which could result in a rapid and damaging catch-up.
Unless and until the Fed does convince the market what its reaction function is, the market will continue to put too much weight on short term inflation and not enough on unemployment.
