The market doubts seriously the notion that the Fed will be willing and able to deliver on the two additional rate hikes for 2023 telegraphed by the June SEP.

It was tempting to call the dots a bluff or, less generously, not credible.

For what it’s worth, analysts generally doubt the dots too. If you thought a July hike was likely headed into June’s pause, you were probably more convinced after Wednesday, but that’s about as far as it goes. Nobody I’m aware of believes the Fed is committed to 50bps of additional hikes this year, let alone more.

A simple criticism masquerading as an explanation goes something like this. The Fed has been in the bubble-blowing business for almost four decades. They’re not going to stop now. Old habits die hard, Jerome Powell isn’t Paul Volcker and this Fed will lose its nerve eventually just like all other Feds since Volcker.

Of course, another way to look at the situation entails suggesting the Fed is fighting the last war and that inflation is going to come down faster than the Fed thinks. That’s what the market is saying, according to Goldman’s Praveen Korapaty, who summed the situation up pretty succinctly. July is clearly “live” and the Fed obviously prefers a quarterly cadence now if they’re going to keep hiking. November seems more likely than September in that context (i.e., assuming a July move), but that’s a lot of time for inflation to moderate. Hence the market’s doubts.

“At the new quarterly pace, a July hike would significantly raise the bar for a hike at the September meeting [so] the November meeting would be the more likely candidate for the second hike that FOMC participants currently envision,” Korapaty wrote. “However, we (and markets, even more so than ourselves) expect substantial cooling of inflation by then, reducing the odds that the Fed would actually go through with the additional second hike.”

Note the reference to the market being “even more” optimistic on inflation than Goldman. The figure below illustrates the point.

As you can see, the spread between Goldman’s forecast and the market-implied path for inflation is considerable looking out a few months.

There are a number of possible explanations, Korapaty said. The simplest is that investors are assuming a rapid deterioration in economic activity, even if they don’t see a recession. Generally speaking, a much softer labor market (for example) and a waning consumption impulse would act as gravity, even on core price growth.

Goldman’s subjective recession odds are much lower than consensus. Earlier this month, the bank’s Jan Hatizus reversed the upward revision to the bank’s recession probabilities associated with SVB. The bank’s econ team is now “more confident” in the notion that the drag on real growth from the bank stress will prove modest, even as the economy is “getting a sizable boost from the recovery in real disposable income and the stabilization in the housing market,” Hatzius said. That in part explains why the market’s outlook for inflation is lower than Goldman’s — it’s the difference in opinion on the likelihood of a US recession.

Relatedly, Korapaty cited expectations of ongoing consumer resilience, “particularly on the spending and income gains fronts,” alongside a sturdy labor market. When taken together, the implication is that inflation progress “could be slower than what markets are currently pricing.”

He also mentioned the possibility of “delayed onset inflation” in categories like healthcare, which Goldman suspects at least some market participants might be “ignoring.” And then there’s commodities. Goldman’s inflation outlook obviously includes forecasts for energy, but Korapaty said investors may be “even more bearish on energy prices than what is implied by commodities futures.”

In the end, Goldman doubts inflation will be persistent enough to force the Fed into another hike after an assumed move in July, and part of the reason is that the bank expects inflation to moderate enough by November to satisfy officials that merely holding at terminal would be sufficient. The market is even more optimistic — or more pessimistic, if the reason for harboring a benign inflation outlook is down to expectations for a hard landing.

On the bright side (and I mentioned this a few days ago), a lot of this does point to a more compressed distribution of outcomes at the US front-end, and to the extent choppiness there was a source of consternation in 2022, I suppose we can look forward to calmer waters ahead. Even if inflation hangs around, Korapaty wrote that, “vol should remain on a downward trajectory since a quarterly pace of hikes would reduce the chance that the Fed overshoots by a large margin.”