Markets Expect The Fed To Pause In 2023, Will It?

Assessment of the US Federal Reserve’s (Fed’s) actions in setting monetary policy often revolve around key terms. In 2021 and early 2022 we had the idea that inflation was “transitory”, which proved largely false. Over the summer we had the risk of inflation becoming “entrenched” most notably at Jerome Powell’s Jackson Hole speech, leading to further large rate hikes.

In more recent speeches, we are hearing talk of a “pause”. This is the idea that the Fed will stop hiking rates for a period to assess if and how its policies are working. The markets appear to see a pause as likely and recent Fed speeches are starting to hint at it. So will it happen?

Why Pause?

A pause is likely to be part of sound monetary policy. Interest rates can be described as a brake lever for the US economy, like brakes on a bike. At 0% interest rates, there is no brake applied and the wheels of the economy spin very freely.

At higher levels of short-term rates such as 2% or 4% interest rates start to add friction and the wheels of the economy slow. That analogy helps explain why the Fed is apt to pause. At some point, the brakes are fully applied to the US economy. Indications suggest that may happen with interest rates at around 5% or so.

The challenge is that monetary policy, unlike brakes on a bike, can take up to a year to have an economic effect. It is perhaps prudent to pause once the Fed believes the economic brakes are on. If the Fed has got it right, the brakes will work, but it will take months to see the effect. Recall that the Fed first raised rates this cycle in March 2022, so it hasn’t been a year from even the first interest hike yet.

Downside Risks Of Excessive Interest Rates

Hiking rates excessively carries several risks. While it’s not directly part of the Fed’s mandate, interest rates ultimately cause the cost of government debt to increase. Today, government debt in the US is high. This means that if the Fed were to raise rates too high, the US government may ultimately have a lot of extra spending on interest it didn’t plan for.

The US wants to avoid the situation the UK recently saw, where the markets started to lose faith in its ability to keep its debt under control. Also, remember that the US has a higher ratio of government debt to GDP than the UK does currently.

We should note that there are lot of indicators that a US recession may be coming, including weakness in housing and the recent shape of the yield curve. The Fed currently worries more about entrenched inflation than it does about a recession. Still, it would like to avoid a recession, if it can. That may not possible, but continuing to rise rates too far, may make any potential recession deeper and more painful than it needs to be in order to combat inflation.

Inflationary Risks

There are risks on the other side too. Coming back to the concept of entrenched inflation, the Fed does want to make sure that inflation in the US is coming under control. If the Fed does stop too early, that could cause more problems for the US economy if inflation is not tamed.

So, it’s a challenge. The Fed haven’t seen too many direct signs that inflation is coming down yet in inflation reports. In fact core inflation remains stubbornly high on recent CPI data. Still, many expect the Fed’s policies and other factors to tame inflation in 2023.

Ultimately it comes back to data, and probably inflation data. The markets are betting that we’ll start to see some better inflation numbers at some point in the next 4 months or so. That likely won’t bring inflation back to the Fed’s 2% target, but may suggest inflation is easing.

What To Expect From the Fed In 2023

As always, the Fed manages expectations carefully. It’s likely we’ll see a 0.75 percentage point hike at the Fed’s November meeting. It’s also probable we’ll see another large hike in December, perhaps 0.5 percentage points.

However, the Fed’s 2023 decisions are clearly in play. This is where the markets are anticipating a pause. The timing, though, remains unclear.

One scenario is a ‘tapering’ of rate hikes with 0.75 percentage points in November, 0.5 in December and 0.25 in February, and then the pause hits. However, markets also see a fair chance that rate hikes end as soon as February or doesn’t happen until early summer based on current interest rate futures.

Fed Meeting Dates For 2023

Also, remember that the Fed does not meet each month. Yes, there are meetings in November and December 2022. However, the first scheduled interest rate decision of 2023 comes on February 1. Then the Fed sets rates again on March 22, and skips the month of April to meet again on May 3. It’s these early 2023 meetings when the markets expect the Fed to finesse its approach to any pause in monetary policy.

What To Watch For

The market’s current assessment, which could of course change, is that a pause is coming in the first half of 2023. That’s what’s helped support a recent rally in stocks since mid-October.

Ultimately, any decision to pause will be driven by an assessment that the Fed’s policy is working, which means some indication that US inflation actually is coming down.

Unfortunately, the upcoming CPI data for November may not provide that comfort as inflation may rise around 0.8% month-on-month on current estimates, but we have a lot more inflation data to come before the Fed starts making its 2023 interest rate decisions.

So expect the Fed to ease on rate hikes in 2023, but that likely assumes we see some early and encouraging signs in inflation data fairly soon. We’re not there yet, but markets see it coming over the next few months.

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