Economic Commentary

Economic Commentary

February 1, 2023

Fed steps down the size of rate hikes again, though inflation battle soldiers on

Executive summary

The Federal Reserve (Fed) raised interest rates by a quarter point (0.25%), reducing the size of the hike for the second straight meeting after four supersized hikes of 0.75%. 

During the post-meeting press conference, Chair Powell stated that it’s too early to declare victory over inflation but didn’t forcefully push back against eventually pausing rate hikes.

Markets ran with the potential for a Fed pause as stocks popped during Chairman Powell’s press conference. Meanwhile, yields dropped across the curve in U.S. fixed income markets. 

Chair Powell hinted at further rate hikes, which would help against inflation but will also crimp the economy. In our view, a recession remains our base case as dramatically higher interest rates place additional stress on consumers and businesses going forward. We also maintain our view that, while it has clearly peaked, inflation will remain elevated compared to pre-pandemic levels.

graph of federal funds target   Federal funds target: Markets now expect rates to peak at 4.9% in mid-2023, then falling to 4.5% by year-end '23

What Happened

At its February rate-setting meeting, the Federal Open Market Committee (FOMC) unanimously agreed to increase its target range for the federal funds rate by a quarter point (0.25%) to a range of 4.50% to 4.75%. With today’s move, the Fed has pushed the target rate up 4.50% in the past year from essentially zero.

During the post-meeting press conference, Chair Powell stressed that the battle against inflation isn’t done yet. He mentioned that it’s too early to declare victory over inflation, reinforcing the notion that more rate hikes will be needed to get down to the 2% inflation target.

Powell acknowledged that the disinflationary process has started. For instance, goods prices have ebbed as spending has shifted back towards services. Yet, housing services haven’t peaked yet, though Powell noted that the committee expects that new rents will soften in coming months. (Private source data already shows that new rents are slipping.)

Powell noted the sharp decline in interest-sensitive demand, specifically calling out housing activity, which has been clobbered in the past year.

Regarding possibly pausing rate hikes in the future, Powell brushed off the questions, saying that the committee will update their economic projections in March. It is important to note that no member of the FOMC had a rate cut for 2023 in the December statement of economic projections. He also reiterated their data dependency for future policy moves, including two months of employment and inflation data before the next meeting. He also rightly noted that forecasting inflation is fraught with pitfalls.

Powell also side-stepped several issues, including the federal debt ceiling, though he plainly stated that,” Congress needs to raise the debt ceiling.”

Our Take

Inflation has clearly peaked on nearly every measure. More importantly, the Fed funds target rate is once again above the Fed’s core inflation gauge. Coupled with the dramatic 4.50% increase in the target rate in the past year, this shift in the inflation dynamic allowed the Fed to step down the pace of rate hikes.

Accordingly, we believe the Fed is closer to the end of rate hikes. That said, we maintain our view that scar tissue from prematurely loosening policy in the past is guiding the Fed’s actions. While rate cuts are plausible in the event of a sharper recession, we maintain our view that the coming economic slowdown will be relatively mild. Thus, we wouldn’t rule out that the Fed could continue to hike rates above market expectations, which currently anticipate rates peaking at 4.9% in mid-2023, then falling to 4.5% by year-end.

Chair Powell did get tripped up by the possibility of pausing rate hikes, either because inflation had sufficiently receded or to simply assess the economic conditions. His stumble likely adds to the market’s uncertainty. 

Bond market reaction

The downshift in hikes by the Fed for the second consecutive meeting was widely expected and therefore the press release did not cause much movement in yields. However, Chair Powell’s press conference created swings in yields as he did not push back against the recent loosening of financial conditions as hard as traders had expected he might. Markets took this as a sign that the Fed may not be as aggressive in trying to tighten financial conditions further. Yields dropped across the curve in a somewhat parallel fashion by about 10 basis points on the day. 

After reaching a high of 4.25% at the end of October last year we recommended a slightly longer duration than benchmark. Since then, the 10-year U.S. Treasury yield has declined significantly and after the press conference broke below 3.40% for only the second time since September. This move makes adding to duration less attractive in the very near term. We would recommend patience in adding to duration now given the 10-year is still close to the middle of the trading range of 2.75%-4.25% to start this year.

The U.S. Treasury yield curve remains inverted though and the 3-month/10-year curve further inverted following the meeting. We expect the yield curve inversion to persist throughout this year as the Fed maintains its policy rate closer to the peak for longer than the market currently expects. The front end of the curve will remain anchored to the Fed funds rate while at the same time longer-dated bonds will continue to price in slower economic growth as we progress through 2023.

Despite the market’s perceived dovishness of the press conference, the Fed’s actions to date have not fully taken effect and still supports our base case view of a U.S. recession this year. Hence, we recommend an emphasis on high quality fixed income, which tends to outperform riskier fixed income sectors in slowing growth environments. Should upward momentum return in U.S. yields, we would view that as a tactical opportunity to extend duration for those portfolios that remain short of their benchmark. The overall rise in intermediate yields last year put core fixed income in a better position to deliver on its two key tenets - income and portfolio ballast – as economic risks rise.

Stock market reaction

Stocks popped around the announcement and moved modestly higher during the post-meeting press conference. Our view is investors are placing too high of a probability on a soft economic landing and leaving little margin for error. The market is trading at an above-average valuation, which we do not view as warranted given above-average macro risks.

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