The Fed Hikes Again, But What About 2023?

Last week was important as the November CPI report was released on Tuesday and that was followed up with the Federal Reserve’s decision to increase the Fed Funds rate by .50% on Wednesday. I wanted to give our thoughts on both.

Let’s start with the CPI report. For the 2nd straight month inflation came in cooler than expected, with prices rising by .10% month-over-month. Expectations were for an increase of .30%. The chart below illustrates how out of control inflation was in the first half of the year with large monthly increases virtually every month. But you can see that the second half of the year has been a different story. There are still categories like wages and food that are still running hot, but most other categories show a major cooling since the Fed began hiking interest rates. The best example is gasoline prices, which have declined back to levels last seen over a year ago at $3.14/gallon.

It is important to note that prices are still high. But inflation measures rate-of-change, and the second half of this year has been an improvement over a brutal first half.

Following the better-than-expected CPI report, the Federal Reserve increased rates by .50% to a range of 4.25%-4.50%. This was in line with market expectations. Fed Chair Jerome Powell said that they expect to hike rates again in early 2023 and eventually take the Fed Funds rate to over 5% and keep it there into 2024. Judging from moves in the bond market, investors believe that would be a mistake.

Take a look at the chart below. Last October rates were near 0% both the 2-year Treasury and for Fed Funds. Many investors believe the 2-year Treasury is a good barometer of where the Fed Funds rate should be. By that line of thinking, throughout 2022 you can see that the Fed has been behind the curve. However, that has now changed, with the Fed Funds rate now being higher than the 2-year Treasury. The reason this matters is that historically the Fed keeps interest rates too low for too long and then they compound their mistake by overtightening, which then sends the economy into a recession.

We were very concerned in 2021 that the Fed was making a policy mistake by keeping rates at 0% and continuing to print $120 billion/month while calling inflation “transitory.” Finally, in March of this year, the Fed began its rate-hike campaign and began to reduce the size of its balance sheet(QT) by $95 billion/month in September. As the chart above shows the Fed has taken the Fed Funds rate from near 0% in March to 4.50% today. That is a significant amount of tightening in just nine months but was very necessary. We believe the bond market has it right, that further rate hikes from here would compound their 2021 mistake. Instead, we believe the Fed should refrain from further rate hikes over the next 2-3 months. This would give them more time to see the ultimate impact of their rate hikes on inflation and the economy. Given the Fed’s history of hiking too high and causing recessions, we hope that when they meet again in late January that they decide to pause. As of now, Fed Futures are pricing in two more hikes of .25%, followed by two cuts of .25% in the back half of 2023, ending the year at the same level rates are today.

Regardless of what the Fed decides to do, the good news is that they are near the end of the rate hiking cycle. This will remove what was a major headwind throughout 2022.