If investors were to hear about the U.S. Federal Reserve’s (Fed’s) decision to increase its policy rate to between 4.25% and 4.50%, read the accompanying statement, or watch the initial market reaction to the rate hike, they could be forgiven for thinking that the day’s events were entirely unremarkable. A closer read of the Fed’s Summary of Economic Projections, however, will have painted a slightly different picture, which is also reinforced by parts of Fed Chair Jerome Powell’s press conference.
The most notable nugget of information to emerge from Wednesday’s meeting was the adjustment to the projected federal funds rate, which Fed officials have raised to between 5.00% and 5.25%, with the bias clearly still being higher. Chair Powell doubled down on the messaging during his press conference, reminding us that each time the FOMC committee revised its expectations over the course of 2022, rates were pushed higher. His statement was somewhat softened by the suggestion that future rate decisions will be data dependent and that we’re close enough to peak policy rates, thereby warranting a slower pace of rate rises to come. The message was clear though: The Fed intends to hike—albeit less quickly than in 2022—and keep rates elevated for longer, despite expectations for weaker growth and higher unemployment, as outlined in other parts of its latest projection.
Into 2023: could the Fed be close to winding down its rate hikes?
Despite the doggedly higher rate projections, there’s nevertheless a clear sense that the Fed is close to winding down its hikes in order to properly assess the impact of 2022’s tightening. We’ve elected to take the more conservative view and expect the Fed to deliver a final rate hike at its March meeting, with the policy rate peaking at 5.25%. We readily concede that rates could wind up 0.25% lower or that the hiking cycle could extend into May; the exact timing and magnitude of the final rate hike will, at this stage, be truly dependent on inflationary data, with modest sequential prints and decelerating year-over-year growth data being critical factors. The good news is that the last couple of CPI releases have clearly signaled that inflation for goods has flattened on a month-over-month basis. Even services inflation, excluding shelter—which is likely going to garner the most attention in 2023—has stabilized for now.
As soon as the Fed stops hiking rates, markets will be clamoring to find out when the first rate cut could occur. The answer from the Fed is that we should expect to stay pegged at peak rates for an extended period of time in order to avoid the mistakes of the 1970s and to ensure that inflation returns to its 2% target. Taken together, this implies that policy easing is likely to take place sometime in 2024.
"We’ve elected to take the more conservative view and expect the Fed to deliver a final rate hike at its March meeting, with the policy rate peaking at 5.25%."
That’s not how we—or the markets—see it
We have a different view: We expect the Fed to begin easing before the end of 2023. That begs the questions of how do we get there, and how to identify the key signposts that can tell us that we’re on our way.
First and foremost, while we wouldn’t expect inflation to fall back to the Fed’s 2% target, we would need to see a clear and sustained moderation in inflation. Month-over-month data on prices appears to be reverting to more normalized levels—that’s a positive. Specifically, easing core goods inflation has been providing a welcome respite from the uncomfortably high readings we saw in Q3, and it’s likely to provide continued relief to those areas most distorted by the pandemic and Russia’s invasion of Ukraine.
The trickier part is cooling services inflation (ex-shelter) because that’s usually driven by wage growth and is, in our view, the bigger risk for persistently higher inflation over the medium term. Unfortunately, the most likely way that this component will cool is through a recessionary environment. As such, a cooling labor market is a necessary precondition for services inflation to ease. We would expect to see a deterioration here in the early months of 2023.
The bottom line
The good news is that inflation is finally coming down far enough to allow the Fed to consider pausing its tightening actions. The bad news is that we believe the next phase of Fed policy—monetary easing—will more likely be driven by deteriorating economic conditions than by a more benign soft landing.
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person.
All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment, or legal advice. Clients and prospects should seek professional advice for their particular situation. Neither Manulife Investment Management, nor any of its affiliates or representatives (collectively Manulife Investment Management) is providing tax, investment, or legal advice.
This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Manulife Investment Management shall not assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer, or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment approach, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
This material has not been reviewed by, is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by Manulife Investment Management and its subsidiaries and affiliates, which includes the John Hancock Investment Management brand.
Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.