Fed Seeks to Balance Competing Risks

At its first meeting of 2023, the U.S. Federal Reserve (Fed) faced competing priorities: how to acknowledge the progress made on inflation – and signal that rate hikes won’t go on forever – while still maintaining a sufficiently restrictive stance of monetary policy as measured across a broad range of assets. Although Fed Chair Jerome Powell repeatedly emphasized the Fed’s resolve to “not stop before the job [on bringing down inflation] is done,” his assessment of the risks of doing too much versus too little shifted toward a more balanced tone. Indeed, he even said that if inflation falls faster than the Fed’s current projections, there would be less need for restrictive policy and the Fed would also cut rates more quickly than it is currently projecting. These messages, coupled with Chair Powell’s interpretation of the current market pricing as reflecting a more benign inflation outlook than what the Fed is currently expecting, suggest that Chair Powell did not set out to aggressively realign market pricing with the Fed’s forecasts.

The Fed’s latest projections suggest it will hike twice more this year – i.e., 25 basis points at each of its next two meetings, in March and May. However, our assessment of Fed communications to date alongside our baseline for a modest recession leads us to expect one more 25 basis point (bp) rate hike in March before the Fed pauses, followed by gradual rate cuts beginning sometime in the second half of this year.

Interpreting the Fed’s guidance in light of macro developments

Little changed in the February Fed statement: Guidance on future rate hikes softened slightly from a focus on the pace of hikes to a focus on the extent of further hikes.

Following February’s 25-bp hike, the target range for the fed funds rate sits 50 bps below the median dot where Fed officials projected the rate could peak in 2023, according to the most recent (December) statement of economic projections, or SEP. However, markets are pricing the fed funds rate to end the year about 75 bps below the 2023 median dot.

This divergence between market pricing and Fed projections is part of the balancing act officials face amid economic data suggesting monetary policy tightening to date is cooling the economy against the risks stemming from inflation that is still too hot (and well above the Fed’s target). While Chair Powell tried to push back on the likelihood of rate cuts in 2023 barring a downside inflation surprise, he stopped short of clearly signaling an additional rate hike in May.

Since their last meeting in December, Fed policymakers heard further good news on U.S. inflation: Their preferred measure, core personal consumption expenditures (PCE), fell to 2.9% on a three-month annualized basis (per December data), while the latest employment reports suggest wage inflation may have peaked. Meanwhile, U.S. activity indicators have deteriorated, with consumption and manufacturing activity contracting in November and December.

Financial conditions in the U.S. have eased somewhat in light of recent positive CPI (Consumer Price Index) and PCE inflation reports – echoing similar trends in 2022 (for details, see this recent Viewpoint by Rich Clarida). With Fed officials continuing to see greater risk from doing too little to cool inflation versus doing too much, Chair Powell reaffirmed that the Fed plans to hike further as it seeks to keep financial conditions sufficiently tight.

Our forecast: One more hike

Nevertheless, given the recent weakening in various U.S. activity indicators, and the better inflation news, we believe the Fed’s pause isn’t far off. Indeed, if recent economic trends continue as we expect – we forecast a mild recession in the U.S. in 2023 – then the Fed should have enough data in hand at the March meeting to hike and signal a pause.

Please visit our Inflation and Interest Rates page for further insights on these key themes for investors.