February Fed meeting: Tough talk for a smaller hike
At the conclusion of its inaugural policy meeting of 2023 today, the U.S. Federal Reserve (Fed) delivered a smaller, quarter-point rate hike, as widely expected by markets. This was the smallest increase in the central bank's key lending rate since March of 2022, when it first kicked off its tightening campaign. With the increase, the overnight rate now stands between a target range of 4.5% to 4.75%—the highest level since 2007. Markets were resilient in the wake of the latest rate hike, with the benchmark S&P 500 Index generally trading higher immediately following the press conference.
Restrictive monetary policy is weighing on the U.S. economy
It's clear that the U.S. economy is slowing down under the weight of restrictive interest rates. One of our favorite economic indicators—the Institute for Supply Management's new orders index—fell to 42.5 for the manufacturing sector this morning. You have to go back 72 years to find a lower reading for this index, outside of an economic recession. Admittedly, it's just one data point, but it is indicative of the broader slowdown we see taking hold across various leading indicators.
Price and wage inflation have decelerated in recent months, too. This is a welcome sign, but the Powell Fed has not seen enough progress here to say that the inflation fight is over. This is most evident in the FOMC (Federal Open Market Committee)'s post-meeting statement, where the committee notes that "inflation has eased somewhat but remains elevated" and that it "anticipates that ongoing increases in the target range will be appropriate." Economists had speculated whether the plural increases in this latter line might be softened as the Fed nears the end of its rate-hiking campaign. This wording was left unchanged in today's statement—likely deliberately—to send a strong message that the Fed remains committed to bringing inflation all the way back down to 2%.
Inflation is abating, but still too high
Our assessment of the inflation data is likely not very different from the Federal Reserve's. As supply chains gradually recover, we see encouraging progress from goods prices flipping back into deflation—this is where the first surge of high inflation came from, and deflation was the norm for these items in the 25 years leading up to the COVID-19 pandemic. We also see encouraging progress that the property market is cooling. While this has not flowed through into the consumer price index yet, we are confident it will over the course of 2023 as home prices and the prices of newly-signed rental contracts have downshifted markedly. Nominal wage growth has also cooled off. The employment cost index rose at a 4% annualized pace in the fourth quarter of 2022—a notable improvement from the nearly 6% run-rate earlier in 2022. But is still too high to be completely confident that price inflation will fall all the way back down to the 2% target on a sustained basis.
Our view: Additional rate increases not necessary
In our view, further rate hikes are no longer warranted. Given the lags with which monetary policy works, given the marked slowdown in leading economic indicators and given the deceleration in price pressures, we believe a reasonable, forward-looking central banker might want to pause now to see how developments unfold. Ultimately, Chair Jerome Powell and his colleagues on the FOMC get to decide how far they go in raising rates.
We think strongly guiding to a 5.0%+ policy rate is a mistake at this later, uncertain stage of the economic cycle. At the moment, the Fed appears to be acting on risk management grounds—wherein its views the costs of failing to keep inflation anchored at 2% as larger than the cost of causing an economic recession.
A natural translation of the Fed's posture would be to conclude that the risk of a recession in the United States is much higher than normal. That is our view. Mapping that economic outlook onto markets is particularly challenging right now, given many of these concerns are shared by the consensus. The area of the market that looks the most attractive to us is short- to medium-term U.S. Treasury bonds. 4.0%+ Treasury yields are well above expected inflation, and we believe they offer good value and diversification properties into a possible slowdown.