Amid unprecedented high inflation worldwide over the past 12 months, the Federal Reserve (the “Fed”) has taken strong measures to control U.S. prices. At 4.25%-4.5%, interest rates are at the highest level since 2007.
The Federal Open Market Committee (FOMC) meeting at the end of this month will announce the next move on short-term interest rates on February 1. What can we expect in this meeting and for the year ahead? And what does it mean for investors?
A brief look back
At the beginning of 2022, inflation was widely believed to be transitory. As it continued to rise, the Fed started a series of sharp interest rate increases, as high as 0.75% per session, raising rates from near zero in January 2022 to almost 5%.
The repercussions of the war in Ukraine on commodity prices may have compounded the problem. But the root cause is an over-abundance of money following years of low rates, quantitative easing and stimulus measures.
When consumers begin to spend their savings, businesses respond by hiring more staff. Wages rise amid growing competition for labor. To pay for higher costs, they often raise prices further, leading workers to demand higher pay, creating a self-reinforcing upward trend.
The Fed has been trying to address this cycle using interest rates to apply the “brakes” on a potentially overheating labor market.
Context for the first Fed meeting of 2023
The minutes from the December Fed meeting forecast a range of 4.9%-5.6% for the federal funds rate in 2023. Officials also indicated that the pace of increases may slow to limit risks to the economy. But it seems certain that rates will continue to rise, crossing the 5% level.
How fast, how high and for how long rates will rise depends largely on how inflation and wage growth develop in the initial months of the year.
The latest figures are encouraging. Data released on January 6 show employment at a 16-month high, with wage growth declining to 6.1% from 6.4% in the previous month.
The latest consumer price index (CPI) figures show that inflation cooled further in December, with a headline rate dropping to 6.5% from 7.1% in November and a 9% peak in June. Core inflation (excluding food and fuel) also declined from 6% to 5.7%.
If the price of goods continues to drop as supply chains recover, headline inflation may continue its downward trend into 2023, although inflation in services (excluding housing costs) is still rising (+0.3%).
Expectations and Implications
On the day of the latest inflation data release, Patrick Harker, the president of the Federal Reserve Bank of Philadelphia, indicated that future increases of only 0.25% may be appropriate following the steeper hikes last year.
Based on 30-Day Fed Fund futures pricing data, markets expect two more 0.25% rate hikes in February and March, and no further change until December, when rates begin to decline slowly.
With its dual mandate to control inflation and maintain high employment, the Fed has a difficult path this year.
Tackling inflation with higher interest rates has only been possible due to continued economic growth. But even if rates remain unchanged after March, the quest to cool wage growth may restrict economic activity. The longer rates remain high, the greater the risk that another unexpected crisis, such as the Ukraine war, could tip the US economy into recession.
The Fed is hoping for a “soft landing” as the ideal outcome, or a strong economy combined with cooling wage growth.
With so much uncertainty, investors should adopt the attitude of the Fed: cautious optimism with readiness to change course as circumstances evolve.
The global economy may start to improve as it passes the critical point on inflation, but the journey to recovery is far from complete, let alone assured.
 Federal Reserve - https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20221214.pdf
 Reuters - https://www.reuters.com/markets/us/fed-meeting-minutes-may-point-rate-hike-endgame-new-debate-phase-2023-01-04/
 Forbes - https://www.forbes.com/sites/simonmoore/2022/12/15/fed-sees-further-hikes-in-2023-heres-what-could-change-that/?sh=45245e685a17)
 Atlanta Fed - https://www.atlantafed.org/chcs/wage-growth-tracker
 U.S. Bureau of Labor Statistics - https://www.bls.gov/news.release/cpi.nr0.htm
 Barron’s - https://www.barrons.com/articles/3-fed-presidents-speak-today-51673474854
 CME FedWatch - https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
 Reuters - https://www.reuters.com/markets/us/us-jobs-report-breathes-life-into-feds-soft-landing-scenario-2023-01-06/
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