The Fed, Interest Rates, and Markets Going Into 2023

The December Fed meeting provided the markets with no surprises as a 50-basis point increase in the Fed Funds Rate pushed it to 4.25% to 4.50%. In March 2020, the short-term rate was at zero to 25 basis points. After calling inflation “transitory” through most of 2021, the data-sensitive central bank awakened. While late to the inflationary party, the Fed played catch-up from March through December 2022. 

Meanwhile, quantitative tightening to reduce the Fed’s swollen balance sheet is a new monetary policy tool that JP Morgan’s CEO Jamie Dimon warns could significantly impact the economy. “We’ve never had it before ever in the lifetime of mankind, so I look at that as something we should be quite concerned about. And you know, this suppression of the 10-year bond rates has been going on for 20 years, and it can’t really be suppressed anymore.”

A move to 4.375% in the Fed Funds Rate and quantitative tightening has taken a toll on markets across all asset classes over the past months. However, inflation remains at the highest level in years despite the Fed’s aggressive monetary policy stand.

CPI and PPI data say inflation remains steady

The November producer and consumer price index data presented conflicting inflation readings. The PPI increased by a higher-than-expected 0.3% for the month and was 7.4% higher than the previous year. The November CPI rose by a lower-than-expected 0.1% and was up 7.1% from the same time in 2021. 

Chairman Powell acknowledged the improvement in inflationary pressures at the press conference that followed the December 14 FOMC meeting but cautioned that continued rate hikes are appropriate. The Fed’s statement was hawkish, but the Chairman tempered it by saying the central bank will raise rates at a “slower pace.”

The labor market is tight

One of the issues pushing inflation higher is a very tight U.S. labor market. The decision to increase the Fed Funds Rate by 50 basis points to 4.25% to 4.50% was unanimous, with seventeen of nineteen Fed officials forecasting a rate of over 5% in 2023. The central bank increased its 2023 median rate expectations to 5.1% from 4.6%. Moreover, the Fed will continue to reduce its balance sheet by $95 billion monthly. While the committee believes rate hikes will lead to a higher unemployment rate in 2023, it increased its GDP forecast from 0.2% to 0.5%. While acknowledging the lag between interest rate increases and the economic impact, the Fed believes inflation will gradually decline over the coming months. 

An economic or a political problem?

Real interest rates remain negative. With the inflation rate north of 7% and the Fed Funds Rate at a midpoint of 4.375%, real rates are negative 2.625%. The Fed reiterated its 2% inflation target, which is well below the recent reading. When asked if the central bank will consider increasing its inflation targets, the Chairman said there are no plans to lift it from 2%. 

The Fed aims to engineer a soft landing for the U.S. economy via its hawkish monetary policy. While the central bank waited far too long to increase rates to combat inflation, many market participants worry that the current hawkish path will push the economy into a deep recession. If inflation continues, stagflation could grip the economy in 2023, and rising prices could be a political instead of an economic problem, making the financial condition immune to the Fed’s monetary policy path.

The war in Ukraine, sanctions on Russia, Russian retaliation, the alliance between Moscow and Beijing, and the bifurcation of nuclear powers have economic impacts. Food and energy prices are in the crosshairs of the geopolitical landscape, and they are critical inflation variables. The highest oil, natural gas, coal, grain, and other food prices in years are pushing inflation higher because of supply-side issues. The Fed’s policy deals with the economy’s demand side, so the hawkish money policy path may not have the desired effect without a political solution to the war in Ukraine and a return to normalized relations with Moscow and Beijing.  

Dimon calls quantitative tightening unprecedented, and so is the bifurcation of nuclear powers

JP Morgan’s Chairman warned that quantitative tightening via the central bank’s balance sheet reduction is an unprecedented event that could weigh on economic growth. 

The long-term chart of the U.S. 30-Year Treasury bond futures highlights that the long bond futures have fallen off a cliff over the past months. While the futures had recovered to over the 131 level on December 16, the decline to 117-19 on October 2022 pushed the long bond to the lowest level in over a decade since February 2011. 

Meanwhile, the current Fed Funds Rate at 4.25% to 4.50% is sitting at a fifteen-year high, with the Fed telling the market it is heading over 5% in 2023. Jamie Dimon has warned that quantitative tightening could push interest rates to a level where the U.S. economy experiences a hard landing or crash. Meanwhile, the geopolitical landscape with China/Russia and their allies on one side and the U.S./Europe and their allies on the other presents another set of challenges as we head into the New Year. Markets reflect the economic and geopolitical landscapes, which remain highly uncertain in late 2022. 

Geopolitics will determine the path of interest rates and markets in 2023

Geopolitics is the most critical issue as we head into 2023. While inflation and the potential for a recession will dominate economic debates, the path of economic growth or contraction and many prices depend on relations between Washington, DC, Beijing, and Moscow. An end to the war in Ukraine and reproachment between China and the U.S. would calm markets, as it would alleviate some commodity-based inflationary pressures. Moreover, a more stable world that reduces the risk of nuclear conflict will cause a return of optimism to stock and bond markets and cause the Fed to reach an interest rate level that achieves zero or slightly positive real interest rates. 

The bottom line is the root of the current economic challenges is the geopolitical challenges facing the world. As a nuclear conflict has no winners, an optimistic approach to markets for 2023 makes logical sense. Let’s hope logic prevails in Washington, Moscow, and Beijing in the coming year. 

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