The aggressive path of the Federal Reserve’s tightening cycle is well documented, with the Federal Open Market Committee (FOMC) raising interest rates 450 basis points over the course of eight consecutive meetings. With the policy rate now approaching 5%, recent strength in some key economic indicators has raised the question if the 2023 ‘dots’ could move even higher at the upcoming March policy meeting.
On a quarterly basis, the FOMC releases its Summary of Economic Projections (SEP), which include the Committee’s median projected path for the federal funds rate at the end of a given calendar year (the so-called ‘dot plot’). In a tightening cycle, the level at which the FOMC stops raising their policy rate is a focal point of investors in these projections. Since the December 2021 FOMC meeting, the peak level for the projected path of the federal funds rate has increased at each quarterly release of the SEP, creating a significant amount of volatility in interest rates, as well as fueling the hotly debated topic among investors as to how much tightening will be enough. To illustrate, the December 2021 ‘dot plot’ indicated a median projected federal funds rate of 2.1% by year-end 2024 and, one year later, it had shifted higher and earlier, to 5.1% by year-end 2023, underscoring the FOMC’s aggressive removal of policy accommodation.
In January, core PCE inflation declined for the third consecutive month, wage growth moderated somewhat, manufacturing activity remained in contractionary territory, and the services sector experienced a sharp decline in activity. Conversely, the labor market remained strong with solid growth in payrolls, a decline in the unemployment rate, and elevated job openings. In response, interest rates declined sharply on the softer inflation and service sector data, and the yield curve inversion increased further. Investors continued to price in a lower peak rate relative to the FOMC’s December ‘dot plot,’ while also expecting the Fed to begin cutting interest rates in the fourth quarter of this year.
Enter February, where investors saw an exceptionally strong payroll report and a sharp rebound in service sector activity just a couple of days following the FOMC’s regularly scheduled policy meeting. Shortly thereafter, the Consumer Price Index showed both headline and core inflation declined again on a year-over-year basis but less than was expected. Furthermore, retail sales for January came in much stronger than consensus expectations. On the heels of this stronger economic data, interest rates have risen once again.
Perhaps the most interesting shift was in the futures market for federal funds, where the implied rate now peaks at 5.35% in August with the first rate cut projected in the first quarter of 2024 (no longer in the fourth quarter of this year). While the recent strength in economic data and hawkish Fed commentary have pushed the market’s view above the FOMC’s 5.1% median 2023 projection, the divergent views over the economic outlook remain, as evidenced by the still sharply inverted yield curve. Currently, a couple more twenty-five basis point hikes appear to be on the horizon, which will likely keep the yield curve inverted as the lagged effects of monetary policy tightening continue to weigh on the outlook.
With the unemployment rate at its lowest point in over five decades, consumer spending resilient, and core CPI inflation at 5.6%, it seems prudent to take the FOMC at their word and expect further policy tightening. The Committee has made it clear they are willing to sacrifice growth and tolerate higher unemployment to bring inflation back to their target, with a preference to get policy to a sufficiently restrictive level and pause, until a convincing, long-term disinflationary trend takes hold. From the Fed’s point of view, prematurely pausing the tightening cycle and having to restart if inflation reaccelerates is the least desired policy path.
In summary, while a significant shift higher in the March ‘dot plot’ seems unlikely, we continue to believe in the FOMC’s resolve to combat inflation and, therefore, remain reluctant to doubt the FOMC’s willingness to redefine the level of restrictive monetary policy if necessary in this highly data dependent phase of the cycle. Holding short-term interest rates higher for longer may be the compromise to significantly higher rates should a conclusive disinflationary trend evolve more slowly than anticipated. In the meantime, given this uncertainty surrounding the path of monetary policy, the recessionary signals from the inverted yield curve, and the conflicting pockets of strength and weakness currently in the U.S. economy, investors should expect volatility to likely remain elevated in the financial markets.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Executive Vice President, Senior Portfolio Manager
Boyd Watterson Asset Management, LLC