The dangers of driving while looking in the rear-view mirror

Finding silver linings in the Fed’s interest rate hikes

SUMMARY

The US Federal Reserve's accommodative monetary policy in 2020-21, along with the huge pandemic fiscal stimulus, set the stage for the surge in inflation this past year. Add to the mix the supply chain disruptions, a war in the Ukraine and other geopolitical events, and you get an inflationary spiral the central bank is trying to manage.


While beating back inflation by raising interest rates has been the Fed’s mission this year, the concern, though, is that its assessment of current levels inflation is based on selective data that is short-term focused. Relying on incoming inflation and employment data – as well as looking in the rear-view mirror at housing inflation – risks overtightening and a not-so-soft landing.

The Fed wants to see the effects of its tightening apparent in employment, but October’s 261,000 job gain – the slowest since December 2020 – is still too fast for the Fed’s liking. Indicators suggest net US employment will drop by about 2 million in 2023, which is enough to push the unemployment rate up to 5.3%.

In other words, the full impact of policy tightening has yet to meaningfully hit the labor market. When employment does fall, the Fed will need to respond. The first rate cut will likely be in the second half of 2023, in line with the Fed’s history. If the Fed dials back from the 75-basis-point pace of the past six months, it might ultimately minimize the severity of the likely 2023 recession.

Looking to November 8, 2022, US mid-term elections, the stock market has performed better when the White House and both chambers of Congress were split between the two parties rather than united under one. Investors seem to be at ease with gridlock in Washington that results from both parties acting as a check against each other.

Stocks also tend to perform quite well in the year following mid-term elections, but we don’t expect this dynamic to be the fundamental driver of returns in 2023.

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