by Peter C. Thoms, CFA
In the opening weeks of 2023, equity markets here in the U.S. and around the world have performed well, signaling a change in investor sentiment from the dour closing months of 2022. Investors seem to think that with inflation on the downtrend, the Federal Reserve is nearing the end of its interest rate increases. But is the Fed really close to finishing, or are equity investors celebrating a bit prematurely?
Good Economic News Puts Damper on Markets
In most circumstances, investors view favorable data about the economy as positive for stocks. Today, however, investors are preoccupied with the Fed’s campaign to reduce inflation to its 2% target by keeping its Fed Funds target rate (now 4.50%-4.75%) elevated for an extended period to slow the economy and to thereby reduce demand for goods and services. A trio of recent economic reports shows, however, that the economy remains quite strong. First, January’s retail sales, which increased 3% versus expectations of a 1.9% increase, reflect healthy spending and a resilient consumer. On a year-over-year basis, retail sales rose 6.4%, which is very close to the current inflation rate. Second, non-farm payrolls increased 517,000 in January, well ahead of estimates, and the unemployment rate fell to 3.4%, the lowest rate in 53 years. Finally, the January Consumer Price Index (CPI) report showed that inflation is continuing to fall, but at a slower pace than in recent months. At face value, these recent economic reports are good numbers for our economy, but they also provide cover for the Fed to continue to attack inflation by increasing interest rates. While it is a matter of record that the Fed usually acts too late and does too much, there is little evidence in the current data that the Fed has gone overboard.
Our View: Rates Higher for Longer
While the Treasury yield curve is forecasting that the Fed will, in fact, be reducing interest rates before the end of 2023, we think that the Fed has little to gain by catering to investor hopes before inflation is vanquished. The recent strong economic data give the Fed the reasons it needs to keep interest rates higher for longer. We see at least a couple more 25 basis point hikes in the first half of 2023 as likely, which would take the Fed Funds rate above 5%. Why? Because there is no good argument (so far) for the Fed not to continue to try to reduce inflation further and there is no sign so far that the Fed has applied too much pressure. For the moment, our economy keeps chugging comfortably down the track. But as the Fed keeps stepping a bit harder on the brake each month, sooner or later the train will begin to slow.
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