Don’t fight the Fed” is one of the most widely quoted investment axioms in financial markets. The idea is simple: since the United States Federal Reserve controls economic cycles and long-term interest rates, investors should align their investment strategy with the central bank’s policies. In the years following the 2008 financial crisis, the Fed kept monetary policy highly accommodative to encourage spending and economic growth. These conditions were a boon to higher-risk assets like stocks, which recorded their most extended bull market in history. Now, the Fed finds itself unwinding a decade of stimulative policies to combat rising inflation, which peaked at 40-year highs in June 2022.
2023 is shaping up to be a challenging year for financial markets. Analysts at BlackRock have warned about a looming recession whose severity will depend on the Fed’s desire or ability to respond. But, for now, central bankers remain focused on their price stability mandate. If investors are hoping to avoid a fight with the Fed in 2023, here are three themes they should watch out for as the year progresses.
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The Upper End of the Federal Funds Rate
The Federal Open Market Committee (FOMC) concluded its December policy meeting by raising its benchmark interest rates by 50 basis points to 4.50%. In its accompanying summary of economic projections, the FOMC penciled in 5.25% as the upper end of the federal funds rate. In other words, Fed officials see interest rates rising further in 2023 as their fight against inflation intensifies. However, the forecast suggests that officials only expect to raise rates by a cumulative 75 basis points in 2023.
With eight meetings planned for next year, the FOMC will have plenty of opportunities to influence policy expectations. The rebound in equity prices from the October low suggests that financial markets expect a pivot toward dovish monetary policy sometime in 2023. So far, the Fed has given no such indication, but investors are betting that the central bank’s focus will shift back to economic growth as recessionary forces continue to build. The March 2023 FOMC meeting could provide more insight into the central bank’s outlook on inflation and GDP as it contains the next summary of economic projections, including the Fed’s dot-plot summary of interest rate expectations.
Acceptable Levels of Unemployment
The Fed’s dual mandate involves pursuing the economic goals of higher employment and price stability. In late 2021, the focus shifted heavily toward price stability after it became apparent that inflation was spiraling out of control. But the Fed’s inflation fight is restricted to the demand side, as raising rates discourages borrowing and spending. The downstream effect of this policy is higher unemployment, something the Fed is prepared to stomach to tame inflation. However, what’s less clear is the peak unemployment that will be required to ease cost-push pressures in the labor market. Currently, wage inflation in the United States is running above 5% annually and unemployment is 3.7%. The unemployment rate was as low as 3.5% in September.
Higher unemployment is foretold by the Fed’s policy measures. In December, the central bank projected that unemployment would rise to 4.6% by the end of 2023, which is 1.1 percentage points higher than the September level. By comparison, unemployment rose by 1.3 and 1.2 percentage points, respectively, during the mild recessions of 1990 and 2001. However, as Pimco noted in a recent analysis, the post-pandemic labor market “has changed in fundamental and complex ways,” making it difficult to forecast how much unemployment can be sustained before a mild recession becomes more severe. In a recent forecast, Deutsche Bank said the Fed’s policies could backfire, leading to a much larger rise in unemployment.
Forward Guidance vs. Actual Financial Conditions
The behavior of financial markets doesn’t always align with Fed policy. As mentioned earlier, equities staged a large relief rally in October and November on expectations that peak inflation is behind us and that further tightening from the Fed wouldn’t be warranted. When the disconnect between Fed guidance and financial conditions gets wider, policymakers may have to intervene in unexpected ways.
On Nov. 30, Fed Chair Jerome Powell told the Brookings Institution that the central bank doesn’t intend to ‘overtighten’ because it doesn’t want to cut rates anytime soon. However, if financial conditions continue to ease due to investors doubting the Fed’s commitment to fighting inflation, a peak policy rate of 5.25% may not be sufficient.
The Fed is likely to tweak its forward guidance in 2023 as it continues to evaluate economic data and financial market conditions. This includes jawboning, or attempting to influence the rate of inflation through moral suasion, in addition to its usual open market operations.
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The Bottom Line
After the Fed’s catastrophic misread on inflation in 2021 and 2022, its legitimacy is at stake heading into the new year. The central bank’s ability to engineer a soft landing won’t be easy and conventional policy tools might not be sufficient to achieve its policy targets. That being said, investors can prepare for most outcomes by monitoring the three themes discussed in this article.
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