2022 ushered in quite the paradigm shift for financial markets, as inflation at levels not seen in 40 years left the Federal Reserve (Fed) with little choice but to aggressively raise interest rates. It marked an end to the 15-year experiment of quantitative easing and shepherded in an era of quantitative tightening. It quickly killed the Fed’s ability to ease financial conditions in the face of equity market weakness, euphemistically referred to as “The Powell Put,” and ended a decade-plus long run of ultra-loose monetary policy. Short-to-intermediate interest rates moved up to their highest levels in well over a decade and bond and equity markets alike responded with the worst down year in recent memory. The Fed’s dual mandate of “maximum employment and stable prices” took center stage last year. Under the “new” paradigm the Fed no longer has the luxury of concerning themselves with equity market stability, instead addressing price stability. While painful for investors, nosebleed-level inflation forced the Fed’s hand and while there may have been debate over the magnitude of rate hikes in 2022, there was seemingly zero uncertainty as to the direction.
Fast forward to the start of the new year and the direction of policy by the end of 2023 seems to be up for debate. Bond markets are pricing in lower inflation and lower short-term interest rates by the middle to the end of 2023 and Fed Funds futures are pricing in rate cuts by the end of this year. Interest rates are well off recent highs with the 10-year US Treasury down 67 bps (basis points) since the peak in late October. There are certainly reasons to justify rates falling. It does seem likely that we are heading for a kinder monetary policy with a reduction in the magnitude of rate hikes, although hikes are likely to occur nonetheless. Inflation does look to be easing. Measures of inflation expectations — such as TIPS (Treasury Inflation-Protected Securities) breakevens — are down near the Fed goal of 2%, while lagging measures of inflation such as Headline CPI (Consumer Price Index) have been falling since the middle of last year. Last week’s jobs report indicated a softening in wage gains and recent data out of the Eurozone indicates inflation is trending down there as well. In addition, there seems to be an almost universal consensus that the Fed will not be able to avoid pushing the economy into recession. This view is supported by an unexpected contraction in the ISM (Institute for Supply Management) Services Index last Friday. Concerns over a pending recession could also help explain the recent drop in bond yields along with the expectation they will continue to fall over the course of the year. While the argument can be made that lower interest rates are justified, could it be that markets have grown too sanguine regarding the rate backdrop?
There is a counter argument that strong labor markets, lingering inflation and a resolute Federal Reserve will keep rates elevated through the balance of the year. Just last week Kansas City Fed President Esther George echoed concerns that inflation is still too high and indicated she sees Fed Funds remaining above 5% well into 2024. Neel Kashkari, a noted Fed dove and FOMC (Federal Open Market Committee) voting member in 2023, projected Fed Funds will need to reach 5.4% to contain inflation — well above the 5% implied by Fed Funds futures. Atlanta Fed President Raphael Bostic stressed last Friday that inflation was still too high and indicated a preference for Fed Funds above 5%. Finally, minutes from the December 13–14 FOMC meeting included forecasts showing 17 out of 19 policymakers expected Fed Funds to be above 5% by year-end 2023, and not one official forecast a rate cut in 2023. Financial conditions have eased considerably since last October and are back to levels we have not seen since the summer of 2022 which is likely not a welcome sight for the Fed. As financial conditions ease it puts renewed pressure on the Fed to keep Fed Funds elevated to try and maintain tight monetary policy. In fact, the last time financial conditions were this easy the Fed promptly gave markets a tongue lashing at Jackson Hole last August. A cacophony of Fed officials sending a coordinated message that seems to contradict market exuberance to the contrary is a road markets have been down recently, and it did not end well.
Recent inflation data has been encouraging, but it is also true that the current level of inflation remains well above the current nominal Fed Funds rate leaving the real Fed Funds rate in negative territory. At some point the Fed likely needs to see real Fed Funds in positive territory and nominal Fed Funds above inflation to feel confident inflation is contained. Furthermore, even though the last increase in non-farm payrolls was the smallest in two years and average hourly earnings moderated more than expected labor markets are still hot by just about any measure. Cooling wage growth is likely a long-awaited sign for the Fed that tighter monetary policy is having the intended impact. That said, the economy still added well over 200,000 jobs, the unemployment rate ticked down to 3.5% and job openings remain historically high. It seems likely the Fed will move forward with additional rate hikes albeit at a much gentler pace than 2022. However, past the first FOMC meeting of the year on February 1, 2023, which is expected to include a 25–50 bps rate hike, uncertainty as to the path forward is likely to grow.
Optimism that the Fed is moving to a slower pace of hikes or possible pause later in the year could well be warranted, optimism they will pivot to rate cuts may well be not.