Up on the Fed funds rate and no pause; Down come the growth projections and no hurrah
The snow has been falling and inflation rates have been easing, but there is no miracle at 20th Street and Constitution Avenue NW, the site of the U.S. Federal Reserve (the Fed). The December FOMC Statement, Summary of Economic Projections (SEP) and the remarks given by Chair Jerome Powell at today’s press conference show that the Fed’s fight against inflation will continue into 2023, potentially bringing some pain before the Fed’s goals can be achieved.
Investors were dreaming of a 50-bps hike
At the November FOMC press conferencee, Powell had signaled that the Fed could moderate the pace of rate hikes as early as the December meeting. In the lead up to today’s Fed meeting, investors were mostly pricing in a 50 basis point (bps) rate hike, a smaller hike than the 75-bps hike delivered at the November FOMC meeting. Today, the Fed delivered that holiday present, raising the Fed funds rate by 50 bps, bringing the target range to 4.25-4.5%.
But no winter wonderland
Unfortunately, the reduction in the size of the rate hikes might have been the only gift investors received. In the December FOMC Statement, the Fed notes that “ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.” This suggests that today’s rate hike was not the last hike in this cycle. In fact, in the December SEP, the median FOMC participant now expects that the Fed funds rate will need to go as high as 5.1% in 2023, hinting that there could be hikes at the next two meetings (in February and March 2023) before the Fed would be able to pause.
With the Federal Reserve having embarked on the most aggressive interest rate hiking cycle since the Volcker era, it is natural that the path ahead will be somewhat bumpy. The Fed lowered its 2023 estimated GDP (gross domestic product) growth rate to 0.5% (down from 1.2% in the Fed’s previous estimate). Meanwhile, the central bank sees the unemployment rate rising to 4.6%, nearly a full percentage point above the current U.S. unemployment rate.
Even though inflation rates have been moderating recently, the Fed expects that the core PCE (personal consumption expenditures) inflation rate will continue to be above its 2% target through 2025. While the central bank notes that there has been some progress in restoring the balance between labor demand and labor supply, ultimately, wage growth rates are still hotter than what they would be comfortable with. And so, the Fed must “stay the course until the job is done.”
On the day of the meeting, the markets gave to me, a bit of intraday volatility
There was a bit of volatility in the equity markets as measured by the S&P 500 Index, swinging from a gain of around 0.7% before the meeting to a decline of around 0.6% by the time the markets closed. However, the magnitude of the intraday fluctuations was smaller than we had seen at some of the other FOMC meetings this year. Bond yield movements were also relatively muted.
O 2023, O 2023, we will be watching closely
With the difficult year of 2022 drawing to a close, investors will be carefully monitoring how 2023 unfolds. From our perspective, we don’t see today’s Fed remarks meaningfully changing our outlook. The latter half of 2022 has been a tug-of-war. On the one hand, leading economic indicators such as PMIs (purchasing managers’ indexes) have been pointing to a potential economic slowdown. The housing market has displayed noticeable signs of softening. Consumer sentiment remains depressed. On the flip side, the labor market still remains resilient, with 263,000 jobs being created in the month of November.
Eventually though, we expect that the lagging indicators will start catching up with the leading ones. With interest rates likely to continue marching higher into more restrictive territory at the next FOMC meeting, we see a significant possibility of further economic cooling. We continue to believe that a mild recession in the U.S. is the most likely outcome for 2023. Against this backdrop, we think that having bonds in your portfolio can serve as an important diversifying tool.