Review the latest Weekly Headings by CIO Larry Adam.
Key Takeaways
- Fed largely expected to raise rates by 0.5%
- Some effects of past rate hikes starting to show
- Powell’s rhetoric will have to thread the needle
The Fed is about to lay all its cards on the table in the final FOMC meeting of the year next week (December 13-14). The Fed’s updated economic projections and dot plot as well as the Chairman’s press conference come at a critical time for the equity market as recent market movements have largely been driven by expectations for how aggressive the Fed still needs to be. In what is arguably the last major economic event of 2022, the financial markets will be monitoring how the Fed balances its focus on inflation (e.g., the increase in the terminal value of the fed funds rate) versus the risk of recession. Recent Fed member speeches appear to be more balanced as they have focused on this two-sided risk of raising interest rates, and investors hope the Fed signals it will turn the tables in 2023 with a rate cut.
- What Will The Fed Bring To The Table? | Much has happened since the Fed last updated its economic projections on September 21—another 0.75% interest rate hike, three months of economic data (including cooler-than-expected inflation readings for October and a slight improvement in sentiment), and another earnings season with the accompanying CEO forward guidance. Below is our summary of how we believe the Fed will revise its economic projections and policy outlook at next week’s meeting.
- Economic Growth | At the September FOMC meeting, the Fed lowered its 2022 GDP forecast from 1.7% to 0.2% and its 2023 forecast from 1.7% to 1.2%. We expect a positive shift for 2022’s forecast giventhat healthy job growth has led to a more resilient than expected consumer; however, the 2023 GDP growth rate will likely be lowered as the current 1.2% forecast is well above our forecast of 0.0% and the consensus’ 0.4%. Our forecast is below consensus due to the lagged effects of interest rates moving well into restrictive territory which will slow economic momentum and likely lead to a mild recession in 2023.
- Inflation | The October inflation prints were finally cooler-than-expected, hopefully confirming that the peak was reached in July and sparking hopes that the pattern continues with the November prints—the next Consumer Price Index (CPI) will be released next Tuesday. But since inflation has stayed higher for longer, there is still a natural assumption that the Fed’s targets for headline and core inflation (2023 estimate 2.8% and 3.1% respectively) are unattainable. But that’s not entirely the case. Even though these estimates may be revised slightly higher due to some of the 'stickier' areas of inflation (e.g., food, rent), inflation metrics in the 3-4% range aren’t out of reach. Due to evidence of easing pricing pressures in multiple areas of the economy (e.g., gas prices turning negative on a year-to-date basis, wholesale used-vehicle prices declining over 15% year-over-year in November), a continued and more significant deceleration is likely to unfold over the next several months.
- Unemployment | A substantial adjustment to the Fed’s 2023 unemployment projection of 4.4% is unlikely due to the resilience of job gains and still elevated levels of job openings. However, there are signs that the labor market is beginning to show cracks, as continuing claims rose to the highest level since early February. As economic momentum slows and companies relax the pace of hiring, there may be upside risk to this target, particularly within goods-oriented industries.
- Federal Funds Rate | As of September, the Fed’s 2022 and 2023 fed funds targets were 4.4% and 4.6% respectively. Since the Fed is largely anticipated to hike rates by 0.50% at next week’s meeting, these projections will likely be increased to 4.5% and 5.0% respectively. While the market is pricing in a peak rate slightly above 5% in the spring of 2023, we believe easing inflation and slowing economic momentum will limit the Fed’s need to continue the streak of rate hikes well into next year. But as this is arguably the most important number for the markets, a forecast materially above 5% would be a negative for equities.
- Powell Won’t Table Further Aggressive Action In The Press Conference | The futures market has fully priced in a 50 basis point hike at next week’s December FOMC meeting, and we agree. Thereafter, we foresee a 25 basis point hike at both the February and March meetings. While the futures market reflects the Fed taking additional action from there, we think an evident slowing of economic momentum and a further easing of inflation will allow the Fed to take its foot off the gas. However, Chair Powell will likely try to afford the Fed some flexibility in his press conference. While he will acknowledge some of the growth concerns, particularly for areas of the economy that are showing clear signs of weakness (e.g., housing), he will also caution the market of prematurely assuming a ‘pivot’ in policy—especially since the futures market has a high probability of interest rate cuts at next year’s November and December meetings. Ultimately, this will be another test of how well Chairman Powell can thread the proverbial needle as he seeks to explain the two-sided risks of interest rate hikes and the difference between slowing the pace of hikes and ending the tightening cycle.
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