Investors are expecting the Federal Open Market Committee (FOMC) to once again dial back the pace of its monetary policy tightening campaign at the meeting on January 31 and February 1.
At the December FOMC meeting, the committee eased interest rate hikes to 50 basis points (bps) from 75 bps. This time around, the Federal Reserve will likely raise rates by just 25 bps, and will also continue to allow up to $95 billion in assets to roll off its balance sheet on a monthly basis.
The Fed is trying to navigate a soft landing for the U.S. economy by bringing inflation back to its 2% long-term target while avoiding a recession. The S&P 500 is up 11.5% since the beginning of October thanks in part to investor optimism about cooling inflation, but the Fed will still struggle to decide when to stop hiking interest rates.
A Kinder, Gentler FOMC
The bond market is currently pricing in a 94.7% chance of a 25 bps rate increase on Feb. 1—and only a 5.3% chance of a 50 bps hike, according to the CME Group. If the FOMC meets expectations and opts for a 25 bps hike, it would bring the federal funds target rate to between 4.5% and 4.75%.
The bond market is pricing in a 78% chance the FOMC will raise rates by at least another 25 bps at its March meeting as well.
The Fed will most likely keep letting $60 billion in Treasury securities and $35 billion in agency mortgage-backed securities (MBS) mature and roll off its balance sheet each month. Its balance sheet has dropped from a record high of $8.96 trillion in May 2022 to around $8.5 trillion as of January, but it remains more than twice its pre-pandemic size of $4.15 trillion in February 2020.
In December, the FOMC updated its long-term U.S. economic growth projections, which suggest 2023 could be a difficult year for the U.S. economy. Fed economists project that the U.S. unemployment rate will climb from 3.5% as of December to an average of 4.6% in 2023. They also cut their 2023 U.S. GDP growth forecast to just 0.5%, and reduced the 2024 GDP growth projection to 1.6%.
The FOMC anticipates core personal consumption expenditures price index will continue to rise by 3.5% this year, well above the Fed’s 2% target. Core PCE excludes volatile food and energy prices and is the Fed’s preferred inflation measure. The Bureau of Economic Analysis reported core PCE inflation of 4.7% in November, down from a peak of 5.2% in September.
The Labor Department recently reported that the consumer price index rose 6.5% in December, down from a 7.1% gain in November and a peak of 9.1% back in June 2022. On a monthly basis, the CPI declined 0.1%, yet another positive sign that inflation is finally trending downward.
The U.S. Economy Remains Resilient
The labour market has held up surprisingly well during the current tightening cycle.
On Jan. 6, the U.S. Labor Department reported the economy added 223,000 jobs in December, exceeding economist estimates of 200,000 jobs added. Perhaps the most encouraging news on the inflation front was that wages were up 4.6% year-over-year in December and just 0.2% on a monthly basis.
The most recent University of Michigan Consumer Sentiment Index reading also came in at its highest level since April 2022, suggesting shoppers are shrugging off economists and analysts predicting a recession in the first half of 2023.
Jeffrey Roach, chief economist for LPL Financial, says the University of Michigan survey is a clear sign consumers are convinced inflation is easing.
“Inflation expectations are well-anchored and improving as pricing pressures are weakening across many sectors,” says Roach. “We shouldn’t be surprised if the Fed starts talking about pausing in the near future.”
DataTrek Research co-founder Nicholas Colas says Fed policies were the most dominant stock market catalyst of 2022, but a more stable price environment will likely make the Fed less of a factor for investors in 2023.
“Recent positive data points on wage and general price inflation, as well as better price action in global capital markets, strongly suggest that 2022’s ‘Only the Fed Matters’ paradigm will not be as useful in 2023,” Colas says.
Is a Fed Pivot Coming?
At the upcoming FOMC meeting, investors will be paying close attention to any commentary from Fed chair Jerome Powell that could hint at when investors should expect the Fed to stop raising rates and whether or not the Fed will pivot to rate cuts by the end of 2023.
Kavan Choksi, investor, founder, and business management and wealth consultant at KC Consulting, says the Fed is making progress on its path to normalized inflation, but investors shouldn’t get ahead of themselves anticipating a Fed pivot.
“Things are getting better, and so all eyes are now on the Fed to see whether they take their foot off the gas and hike rates less aggressively. Many market participants are expecting the Fed to start cutting rates before the end of the year, but it may be a little too premature to reach that conclusion at this stage,” Choksi says.
In the Fed’s Own Words
In its December meeting minutes, the FOMC said it will maintain a “restrictive policy stance” until economic data confirms inflation is on a “sustained downward path.” Committee members said it is “likely to take some time” before conditions may be appropriate for easing monetary policy. The FOMC discussed the risks of pivoting too quickly, noting that “historical experience cautioned against prematurely loosening monetary policy.”
In a speech at the Symposium on Central Bank Independence in January, Powell said restoring price stability can require the Fed to take “measures that are not popular in the short term as we raise interest rates to slow the economy.” Powell also noted monetary policy decisions must be data-driven and insulated from “short-term political considerations.”
In January, Federal Reserve Governor Michelle Bowman said inflation is “much too high” and the Fed still has “a lot more work to do” before its job is done. Bowman said she is looking for “compelling signs that inflation has peaked and for more consistent indications that inflation is on a downward path” before she determines how much higher the Fed should raise rates. Bowman also said once the terminal fed funds rate is reached, “it will need to remain at that level for some time in order to restore price stability.”
In the near term, investors will be watching upcoming speeches by Federal Reserve Vice Chair Lael Brainard at the University of Chicago Booth School of Business on Jan. 19 and Federal Reserve Governor Christopher Waller at the Council on Foreign Relations on Jan. 20 for more insights into the upcoming FOMC meeting.
The Fed will also get a last-minute inflation update on Jan. 27 when the Bureau of Economic Analysis releases its December PCE data just four days before the FOMC meeting begins.
Source: Forbes
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