Trying to Make Apple Juice from Oranges: The Problem with Comparing Market Pricing and Fed Projections

While the U.S. Federal Reserve (Fed) appears to be nearing a point where it considers pausing its interest rate hiking cycle, market participants are already pricing in the timing and magnitude of future rate cuts. Specifically, the market appears to be pricing in cuts to the Fed’s short-term policy rate starting in the second half of this year and continuing into 2024 and beyond, with tradable forward rates going from just under 5% by mid-2023 to about 3% in only 18 months’ time.

This pricing is garnering attention from market participants and pundits alike, fostering a debate about what type of economic outcome – namely a hard or soft landing – the market is pricing in. The resulting assumptions can feed into the pricing of different asset classes, creating significant implications for investors.

So what to make of the discrepancy between forwards, one of the most closely watched market rates that price in future interest rate expectations, and the Fed’s own projections (see Figure 1)? Does the market really disagree with the Fed by more than a full percentage point when it comes to where rates will be next year?

We’d like to caution against the false sense of precision that market-based rates can provide, and to suggest that the answer is much more nuanced. Notably, a forward rate should not be viewed as a standalone expectation of where short-term rates will be. Rather, it is probability-weighted.

Dots vs. markets

Each quarter, the Fed’s policy-setting committee publishes a chart, known as the dot plot, summarizing individual members’ projections for the federal funds rate. Each dot distills one member’s range of possibilities into a single, most likely point. However, each dot does nothing to illustrate that member’s entire possible range of outcomes, therefore conveying a higher level of confidence in any given point.