The big news from the Federal Open Market Committee meeting of Dec. 13-14 was the Fed's more hawkish than expected announcements about a higher target for Fed funds rates in 2023 after November consumer price index core data showed that inflation is continuing to decline.
This isn't totally unexpected, however, as the Fed (and other central banks) don't want their slower pace of rate increases to be misinterpreted as a "dovish pivot" as they allow the cumulative impact of prior rate hikes to work through their lagged effects, as previously indicated.
It is good news that U.S. inflation is responding to the Fed's tightening since earlier this year. November CPI punctuates the past five months of CPI running at a 2.4% annualized rate: core CPI inflation (all items less food and energy) rose 0.2% in November, its smallest increase since August 2021. November headline CPI rose 0.1%, after increasing 0.4% in October. Core "goods" prices fell by 0.5%, and core "services" prices rose 0.4% even before the sharp decline in rent inflation kicks in, which private-sector data indicate is coming.
The core November PCE deflator (Fed's preferred measure of inflation), due out Dec. 23, is expected to show a 0.2% monthly increase and a 4.6% rise over the last 12 months. If it and December CPI price data trend similarly to November, inflation over the second half of 2022 will be in line with the Fed's objectives. If the FOMC remains "data driven", there remains a chance that more rapidly declining inflation in December and January will let the Fed pause after its expected Feb. 1, 2023, quarter-percent rate increase.
The Fed didn't disappoint our expectation of "hawkish" push-back to the positive market reaction to declining inflation data. In fact, it doubled down by increasing its December 2022 Summary of Economic Projections ("SEP") view of inflation to bolster its projection of higher interest rates, which sent equity markets down the balance of the week. Fed Chair Jerome Powell said he expects multiple more rate hikes.
The December SEP, compared to the September SEP, shows:
- Higher GDP growth in 2022, but lower growth in 2023, yet still up 0.5%,
- Lower unemployment rate in 2022 but higher unemployment rate in 2023 and 2024,
- Higher headline and core PCE inflation in 2022, 2023 and 2024, and
- Higher Fed funds rates in 2023 and 2024.
It is not clear whether FOMC members truly believe their higher inflation and interest rate forecasts, or if they are being overly hawkish to prevent further market exuberance. Either way, this hawkish "forward guidance," if taken to heart, will slow the economy further and reduce the likelihood of the soft-landing that markets have been hoping for. Meanwhile the Atlanta Fed's GDPNow is still estimating 2022 Q4 real GDP growth at 2.8% as of December 15.
Even with its additional tightening and forecast Fed funds rates now being 50 basis points higher in 2023, the Fed is still showing positive real GDP growth in 2023, with the median rate 0.5% growth and the FOMC members plotting a central tendency of 0.4%-1.0% growth. Consensus economist forecasts are expecting a mild recession in mid-2023 and likely negative real GDP growth on average for the year.
As of December 19, the Treasury yield curve remained inverted with 3-month (at 4.22%) and 2-year (at 4.17%) notably above the 10-year 3.48% rate — a reliable predictor of declining GDP growth. With the Conference Board index of leading economic indicators also declining, it is hard to see how the U.S. avoids a recession in 2023, most likely a mild one in the first, second and third quarters.
For fixed income and equity investors, the headwinds of 2022 look to become the tailwinds of 2023, with inflation continuing to fall, GDP declining in the first half of the year and interest rates falling in the second half of the year. Although bonds showed little reaction to the December meeting pronouncements, they also have an opportunity to benefit from declining interest rates in 2023. Notwithstanding the hawkish Fed commentary after its December meeting, bond markets also expect the Fed to be cutting rates in the second half of 2023.
Although 5-, 10- and 30-year Treasuries, the AGG and investment-grade corporates remain at risk to rising interest rates, they all stand to profit from lower interest rates in 2023. Likewise, U.S. high yield, convertibles, ABS and leveraged loans also benefit from falling rates, and these also can have positive returns with a one percent increase in interest rates, assuming a parallel shift in the yield curve. After the latest Fed meeting, equities finished the week down, but credit was largely unphased.
Overall core bond yields are still near 10-year highs and offer a good alternative for diversification and stepping back into their long-time place as the counterweight to risk assets in a balanced portfolio.
Fixed income yields are up from the end of 2021 through Dec. 16, across the board, in many cases 2x: 3-month Treasury from 0 to 4.2%, 2-year Treasury from 0.73% to 4.17%, the AGG from 1.75% to 4.35% and U.S. high yield from 4.21% to 8.56%. As a risk-alternative investment, the U.S. high yields recently were providing a 10% all-in yield.
When the FOMC meets again on Jan. 31-Feb. 1, 2023, it will have both December CPI and PCE inflation data to consider. If inflation continues to decline as it has in the past six months, the Fed likely will raise its policy rate only 25 basis points and may be ready to pause its rate increases as it assesses the impact of its rate increases over the prior 12 months. If so, the outlook for investing in both fixed income and risk assets becomes even more attractive.
