Fed raises interest rates again by 50bps to 4.50%

• The Fed’s “quantitative tightening” program is now approaching the target cap of $95bn of balance sheet reduction per month, of which $60bn is in Treasuries and $35bn in mortgage-backed securities (MBS). The impact of future reductions on overall market liquidity should start to become clearer in 2023, especially if the economy also enters a recession.
• The Fed adjusted 2023 projected median Core PCE inflation is up from September’s estimated 3.1% to 3.6%. Of note, the FOMC repeated its comments yet again that “inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.” The FOMC statement also said – as it has many times this year - that it was “strongly committed to returning inflation to its 2% objective.”
• The projected unemployment rate slightly increased from September’s estimated 4.4% to 4.6% for 2023. As inflation is already likely moderating strongly into 2023, the magnitude of employment losses in the future will likely be the key factor in the Fed’s calculus on when it believes it can end its rate-hiking cycle and begin cutting rates. These projections show more meaningful expected employment loss in 2023, but not overwhelmingly so, which stays internally consistent with the Fed’s dot plot of showing that it will try to maintain higher rates for longer.
• The projection for real GDP growth was reduced from September’s estimate at 1.2% to 0.5% for 2023. This is an extremely low growth forecast – almost to the point of expecting a recession – and given the statement and the rest of the SEP forecast, likely indicate that the Fed is willing to endure that if needed. (Note that Fed Chairman Jerome Powell explicitly said about this forecast “I don’t think it would qualify as recession.” But it is a very low forecast nevertheless).
• Chairman Powell noted in his press conference after that: “The labor market remains extremely tight” and that wage gains were running well above what would be consistent with 2% inflation. Powell also said that: “We keep increasing that peak rate and we are increasing it again. And inflation risk are to the upside. I can’t tell you we won’t increase it again.” However, Powell also noted that while he had not made a judgement on the size of the February rate hike, “the appropriate thing to do now is to move at a slower pace and feel our way.”

Our takeaways

• The Fed shifted its messaging on rate hikes back on October 21, 2022 – even before its November 2nd meeting – by indicating that it would “step-down” rate hikes from its previous pace of 75bps. It followed through on that messaging on December 14, 2022, with a 50bps hike, so it did indeed “step down”.
• While at the December meeting the Fed did reduce its rate-hike pace to “only” 50bps, the FOMC and Chairman Powell tried to forcefully push back against the narrative that inflation has now receded and so they will soon pause and then cut rates. To a certain degree, they actually indicated the opposite.
• We think that despite lower inflation readings, the Fed will maintain high rates until recessionary conditions are apparent, which we expect by the middle of 2023. At that point in time, we believe the Fed will start aggressively cutting rates in order to prevent an even deeper recession.
• We would suggest that clients look at investment grade rated preferred securities, especially “fixed-to-float” structures which offer yields comparable to high yield credit and which may additionally benefit should the Fed begin cutting rates in the latter half of 2023.