The Federal Reserve Open Market Committee raised the Fed funds rate by 0.50%, to a range of 4.25-4.50%. The vote was unanimous and marks a downshift from a pace of four straight 0.75% hikes. The formal statement language was barely changed from the prior month, offering no new information.
According to the CME Fed funds futures market,1 expectations were high (~80%) for a half-percent change, with chances of a larger hike having steadily fallen since the early November meeting. Based on current quarterly probabilities for 2023, the key rate is expected to rise 0.50% by March to 4.75-5.00%, with little change through June, but then drifting lower to a wider range of 4.50-5.00% by September, which implies either a continued pause or even a slight rate cut. The December assumed level has fallen to 4.25-4.50%, which implies further cuts. Probabilities have changed slightly in recent weeks, with a longer expected pause and drop in the terminal rate, with marked calls for easing later in keeping with higher chances of recession over that stretch. All in all, futures markets put the terminal rate right around 5.00%, with estimates from private economists running plus or minus a quarter-percent around that level. There remains a decent degree of uncertainty about this, again, with the key variable being how long it takes for inflation to ease enough to satisfy the Fed.
Economy. Economic growth expectations for the next few quarters continue to vary widely. The Fed’s December dot plot released today showed an upward revision in 2022 growth by a few tenths to 0.5%, while 2023’s was cut from 1.2% to 0.5%. More immediately, the Atlanta Fed’s GDPNow2 statistical measure this week estimates 3.2% growth for Q4, with their Blue Chip economist forecast calling for a range of roughly 0.0-2.0% (median being around 1.0%). The key question continues to center on the possibility and timing of recession, which underpins the divergence in these opinions. There is still no clear answer, with manufacturing and housing falling back while labor markets remain relatively strong, and some spending held up by consumer savings (although that is shrinking). In fact, some economists are again raising the possibility that the U.S. might skirt recession and achieve a unicorn ‘soft landing.’ (Europe and the U.K. are not likely to be as lucky, due to their energy woes, although conditions have improved and are generally better than first feared.) Related to the recession question is how fast inflation flattens and how much damage is done by higher interest rates in combating prices. Although the Fed has told us that it is willing to cause some ‘pain,’ how much can be endured remains to be determined. The cumulative effect of already-done rate hikes has yet to be fully felt. Looking longer-term, growth expectations aren’t extremely high, with projections of 1-2% common for the next half-decade (1.8% in the Fed’s dot plot), leaving less room for error than in the past. Painted with a very broad brush, low economic growth, and an assumption of inflation continuing lower, interest rate projections could remain more contained than the upward spiral currently feared.
Inflation. In yesterday’s release for November, trailing 12-month CPI decelerated to 7.1% on a headline basis and 6.0% for core (ex-food and energy).3 This was promising, albeit only a single data point. The dot plot showed a revision upward by a few tenths in PCE inflation for 2022-25, although the longer-run target remains anchored at 2.0%. Several inflation components have seen improvement in recent months, notably in goods, while services inflation has remained persistent, driven by labor costs and high housing prices. The part that carries over to owners’ equivalent rent operates with a lag, and with home prices just having started to decelerate from peak levels this year, relief could take more time. Per their own admission, the Fed has been keen on wanting to see a broad and persistent trend downward in trailing inflation, but ‘normal’ remains off in the distance. For as much scrutiny as it gets, the Fed can only control the demand side of the equation, not the supply side. On the side of persistent inflation looms the planned broader reopening of China in 2023, due to the release of pent-up activity onto the world.
Employment. The December dot plot showed the unemployment rate for 2022 falling a tenth from the prior estimate to 3.7%; however, the 2023 level rises to 4.6%—such a sharp turnaround indirectly indicates recession. Labor markets remain strong currently, due to the difficulty in firms finding qualified workers, but also an aging workforce. However, there have been layoff announcements in selected industries, like technology, with other measures like jobless claims and job openings pulling back from record strength. In a few stats, weakening has been blamed on ‘residual seasonality,’ reflecting how data extremes of the past several years have disrupted month-to-month seasonal employment measurements. This is notable, considering the large blip in temporary employment around the holidays, which skews seasonal effects even further. In short, there remain fewer available workers, with the labor market generally harder to measure lately. But, the Fed seems to believe there is plenty of buffer from today’s levels versus the weak labor environment of a typical recession.
In recent weeks, ‘financial conditions’ have been mentioned a fair amount. These include factors that either reinforce or oppose Fed monetary policy—base real interest rates, credit spreads, equity values/risk-taking sentiment, commodity prices, and relative strength of the U.S. dollar. A recent problem is that conditions have been sporadically loosening, counter to the Fed’s tightening efforts. Stock prices rising in reaction to lower inflation is one example; another is the 10-year Treasury note trading at only at a 3.5% yield, well below the short-term rate. Financial markets are savvy in adjusting to new information, and the depth of the current yield curve inversion points to rising risk of a financial ‘accident,’ seen as the Fed going too far relative to an assumed sustainable risk-free rate. The inverted treasury yield curve is arguably one of the most important current metrics.
What are the chances of a Fed pivot? This refers to not only slowing down the pace of rate hikes but also a pause, or an actual reverse in course through rate cuts. Fed member language (both formal after meetings and informal during their speaking circuits) is specifically worded to guide expectations and minimize market surprises. So, the bar is assumed to be high, with rhetoric remaining hawkish and not giving away a pivot. Inflation easing on its own, as supply disruptions and demand factors rebalance, wouldn’t likely be enough to warrant a pivot necessarily, simply a pause. Hypothetically, a pivot could happen if economic conditions weaken to such a degree that financial stability is at risk, and perhaps only if inflation is also behaving as well. That implies there are several conditions needing to be satisfied first for a reversal in course, although markets have been quick to react on any hint.
Higher interest rates in 2022 have obviously eroded asset prices globally, as discount rates have risen in kind. For financial markets, the Fed slowing down would be welcome for greater clarity around equity market valuations in particular. In looking at historical episodes, the Fed has routinely ruined the party, with rising rates a catalyst of countless cyclical recessions. (The few times they haven’t perpetuate hopes for a unique soft landing.) Importantly, equity bear markets have tended to bottom before the ‘worst’ from an economic standpoint. Sentiment for risk-taking still remains poor, which has been a bullish indicator historically as well. The part that has changed is fixed income now offers more enticing return potential, based on the tendency of future returns to track starting yields. That hasn’t been the case for over a decade, but bonds can now take some of the weight off equities as the sole generators of returns for the classic balanced portfolio.
1) CME Group