WASHINGTON - US Federal Reserve chairman Jerome Powell has history on his side as he and colleagues split with Wall Street over how long interest rates will stay high in 2023.

After the fastest tightening of monetary policy since the 1980s, the central bank looks set on Wednesday to increase its benchmark rate by 50 basis points in a downshift after four straight 75 basis point moves to curb inflation.

Such a move – widely flagged by officials – would lift rates to a 4.25 per cent to 4.5 per cent target range, the highest since 2007. Fed officials are also likely to signal another 50 basis points of tightening next year, according to economists polled by Bloomberg, and an expectation that once rates reach that peak, they will stay on hold through all of 2023.

Financial markets agree on the near-term vision, but see a rapid retreat from peak rates later next year. That clash could be because investors expect price pressures to ease faster than moves by the Fed, which worries inflation will prove sticky after getting burned by a bad call that it would be transitory. It could also reflect bets that rising unemployment will become a more weighty Fed concern.

This week’s meeting in Washington is a fresh opportunity for Mr Powell to hammer home his point that officials expect to hold rates high to defeat inflation – as he did in a Nov 30 speech when he stressed policy would stay restrictive “for some time”.

Over the last five rate cycles, the average hold at a peak rate was 11 months, and those were periods when inflation was more stable.

“The Fed has been pushing the message that the policy rate is likely to remain at its peak rate for a while,” said Mr Conrad DeQuadros, senior economic adviser at Brean Capital. “That is the part of the message that the market has consistently not gotten. The estimates of the degree to which inflation will come down are too optimistic.”

At play in the tension between Fed communication and investors are two distinct visions about the post-pandemic economy. The view in markets shows a credible central bank quickly putting inflation on a path to its 2 per cent goal, possibly with the help of a mild recession or disinflationary forces that kept prices low for two decades. 

The yield curve – as measured by the gap between 10- and two-year Treasury yields – is inverted by the most since the 1980s, a signal of an economic downturn ahead.

Financial markets “are simply pricing in a normal business cycle”, said Mr Scott Thiel, chief fixed income strategist at BlackRock, the world’s largest asset manager.

A competing view says supply constraints will be an inflationary force for months and maybe years as redrawn supply lines and geopolitics affect critical inputs from chips and workforce talent to oil and other commodities.

In this thesis, central banks will be wary of progress on inflation, which may only be temporary and could be vulnerable to the emergence of new frictions that cause price pressures to linger.

“Strategic competition” is inflationary, said Mr Thiel. “We expect inflation to be more persistent but also expect the volatility of inflation, and for that matter economic data more broadly, to be higher.”

Swaps traders currently bet the funds rate will crest just under 5 per cent in the May to June period, with a full quarter point reduction coming through by around November and the policy rate ending 2023 at about 4.5 per cent. 

The projected Fed rates path would mark an unusually quick declaration of victory over inflation that is now running three times higher than the Fed’s 2 per cent target.

“The futures curve is a manifestation of the success or failure of the FOMC’s communication policy,” said Mr John Roberts, the Fed Board’s former chief macro modeller, who now runs a blog and consults with investment managers, referring to the Federal Open Market Committee.

It is not only the timing for the start of cuts but just how much money market traders see coming that is beyond the historic norms. The over 200 basis points of upcoming Fed rate cuts now priced into futures markets is the most ahead of any policy easing cycle back through 1989, said Citigroup. 

Futures contracts imply the Fed will call a halt to rate cuts around mid-2025, Bloomberg data shows.

Fed officials have not completely ruled out a quick deceleration in inflation. Mr John Williams, the New York Fed president, said he expects the rate of inflation to halve next year to about 3 per cent to 3.5 per cent.

Goods price inflation has started to cool off and softening rates for new leases on homes should feed into lower reported shelter costs. Services prices, minus energy and shelter, a benchmark highlighted by Mr Powell in a recent speech, decelerated in October.

Investors are also optimistic on price pressures. Pricing in inflation swaps and Treasury Inflation Protected Securities predict consumer prices falling sharply in 2023.

But there are also signs that the road back to the Fed’s 2 per cent goal could be long and bumpy.

Employers added jobs at a pace of 272,000 a month over the past three months. That is slower than the 374,000 average in the previous three months, but still robust and one reason why demand is holding up.

Historically, Fed officials note, there is a sticky quality to inflation, meaning it takes a long time to wring it out of the millions of pricing decisions businesses and households make each day. They are also measuring the achievement of their policy as securing 2 per cent inflation, not 3 per cent, and may be reluctant to start reducing borrowing costs if inflation gets stuck above their target.

Mr Williams, for example, does not expect any cuts in the benchmark lending rate until 2024 even though he expects a decline in inflation measures in 2023.

Ms Kathryn Kaminski, chief research strategist and portfolio manager at AlphaSimplex Group, said “people like to focus on things going back to where they were”. But the trend of higher rates can last for quite a while, and “that is something people are underestimating”. BLOOMBERG