Fed hikes by a little less, but promises more to come
After hiking its policy rate by 75 basis points at each of the prior four meetings, the Fed took its foot off the brakes a bit, raising rates by only 50 basis points at its final meeting of the year. Inflation concerns remain, despite a string of softer data, but risks to higher prices and slower growth now appear more balanced than they have for several years.
The U.S. Federal Reserve broke its streak of 75 basis point (bps) hikes, but made it clear it has more work to do to tame inflation as it raised its policy rate by half a percent to a 4.25% - 4.50% range.
The Federal Open Market Committee’s (FOMC) accompanying materials, including updated forecasts, were less optimistic about growth and employment compared to September. Meanwhile, the committee’s median expectation moved higher for the level of rates at the end of both 2023 and 2024.
The Committee made almost no changes to its statement, foregoing an opportunity to point out that inflation readings had moderated in recent months. Fed Chair Jerome Powell pointed out in his press conference that inflation remains elevated and the labor market is out of balance. He provided little to no hope for those looking for signs that the Fed may be ending its tightening cycle in the near future.
The Fed isn't quite done yet
Comments from Fed officials leading up to this meeting heavily hinted at upward revisions to their forecasts for policy rates. And that’s just what they delivered. The median expectation for the fed funds rate at the end of 2023 rose to 5.125% from 4.625% in September. The forecast for 2024 remains quite dispersed among individual members, but clearly calls for rate cuts. The median expectations are for about 100 bps of easing in that year.
Economic forecast revisions were generally more pessimistic. Growth is expected to be just 0.5% next year, as unemployment rises to 4.6%. The Fed also expects core inflation to be stickier, falling to only 3.5% by the end of next year. This higher forecast is consistent with the view that interest rates will still need to be above 5.0% in a year’s time.
Searching for a soft landing
It’s unusual for a major data release to drop while the Fed is meeting, but that’s just what we got yesterday with the release of the November report on U.S. consumer price inflation. This release provided further evidence that the slowing rate of price increases over the past few months is solidifying into a durable trend.
While food and rent inflation remain persistent and could prove sticky, falling goods prices and the complete reversal in energy costs have caused inflation to moderate more quickly than markets (and, perhaps, the Fed) were prepared for. The average gasoline price is back to where it started the year. The plummeting cost of diesel fuel, in particular, is a welcome expense cut for businesses in a wide range of industries.
Even beyond the volatile energy sector, we see evidence that disinflation and, in some areas, outright deflation has taken hold. Core goods price inflation has eased to 3.7% from a high of 12.4% earlier this year. And core services inflation, while still elevated, is close to peaking with leading indicators pointing to a slowing pace of growth in wages and rents.
Signs of softer inflation have allowed uneasy optimism to take hold of financial markets. Corporate credit spreads have narrowed, betraying little concern about impending defaults. Equity markets have climbed significantly from their mid-October lows. The Treasury market is a notable exception, with the 10-year note yield dropping about 70 bps from its 24 October high of 4.24%. Normally, plunging longer-term interest rates and a steeply inverted yield curve are flashing warning lights for recession. But an equally plausible explanation at the moment is that investors expect softer inflation to translate into lower interest rates, even in the absence of a severe recession. For that to prove correct, however, we would need to see a Fed pause or pivot on rates soon.
With rates now firmly in restrictive territory and likely to increase further in the opening months of 2023, we believe a soft landing may be too much to hope for. But a worst-case hard landing has also become less likely, given consumer strength, persistent hiring demand in most industries and strong evidence that inflation has peaked.
Navigating the markets in 2023
Because we think the Fed will make good on its pledge to raise rates by more than the market expects, we approach 2023 with a degree of caution about risk assets. Inflation surprises and the rate hikes that follow them were toxic for just about every asset class in 2022. The higher rates go, the more likely we are to see acute economic stress, including declining company earnings and rising concerns about corporate defaults.
As we prepare our portfolios for a further slowing in global growth, we have upgraded our preference for high-quality bonds, including both U.S. corporates and U.S. Treasuries, while slightly downgrading our view of U.S. high yield and senior loans.
Within equities, we are neutral on U.S. large cap and negative on other global public markets given our concerns that tighter economic conditions are not yet baked fully into consensus earnings forecasts. We have also downgraded private real estate, where prices have likely not yet adjusted to the new higher rate environment and further weakness seems likely in the coming quarters.
This defensive mix is appropriate as we enter a year marked by uncertainty about falling inflation and the related policy response. However, we think investors who extend duration and emphasize quality in their portfolios may benefit from today’s higher yields and the potential for price appreciation in both a soft and hard landing.
Federal Reserve Statement, December 2022.
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