The Fed meets for the first time in 2023 between January 31 and February 1. After all the interest rate hikes over the past year, what can we expect from this meeting? Here’s what the experts think.
Franck Dixmier, Global CIO Fixed Income at AllianzGI
After four 75bp hikes followed by one 50bp hike at the last Federal Open Market Committee (FOMC) meeting, the Fed should move to a more modest pace as it approaches its terminal rate. We expect a 25bp hike at the 1 February meeting.
With this 25bp step perfectly anticipated by the markets, investors may instead focus on Jerome Powell’s communication for the next steps.
Inflation has indeed fallen significantly in recent months. After peaking at 9% in June 2022, headline inflation stood at +6.5% year-on-year at the end of December. Core personal consumption expenditures (PCE), the Fed’s preferred measure of inflation, reached +4.4% at the end of December, confirming its deceleration from a peak of +5.20% at the end of September 2022. But if recent trends validate that the inflation peak is behind us in the US, core inflation remains high, in a context where economic activity continues to show some resilience.
As a result, we do not expect any complacency from the Fed. It should reaffirm its willingness to keep rates high for a long time to come, in order to ensure a sustainable decline in inflation towards its price stability objective.
Market expectations include two additional 25bp hikes over the next few meetings to reach a terminal rate of 5% in Q2 2023, followed by almost 75bp of rate cuts over the second half of this year. To us, this seems to underestimate the Fed’s willingness to maintain restrictive conditions for longer. The meeting is likely to generate volatility, including an upward recalibration of short-term rate expectations over 2023. The impact should be more significant on the short end of Treasuries, which is less protected than the long end.
Kevin Thozet, a member of the investment committee at Carmignac
In the US, the expected level the Fed will bring interest rates to (a.k.a. the terminal rate) has been stubbornly stable, hovering around 5% since last November when core inflation finally started to roll over. Indeed, the Fed being more data-dependent means all eyes will be on the numbers published and most notably on the impending Employment Cost Index (ECI) which provides a more reliable and comprehensive assessment of wage dynamics and hence, core inflation dynamics. As such, our expectations for the 1 February FOMC meeting derive from our own forecasts for the ECI (published on Tuesday 31 January).
Our analysis points at the ECI coming out at +1.2% for the fourth quarter of 2022 (i.e. +4.9% on a year-on-year basis, lower than the 5% of Q3-2022 which was already lower than Q2-2022). While such a print does point at a decelerating wage inflation dynamic, and hence lesser risk of a wage-price spiral, it remains at odds with (or uncomfortably higher than) the 4% level of wage inflation suggested by the recently published average hourly earnings.
In light of this, the latest publications in headline inflation and hard economic data also surprisingly on the downside, the disinflation trend is vindicated. This means the Fed should hike at a slower pace from now on and proceed next week with a “normal” hike of 25 basis points, bringing Fed Funds to the edge of the terminal rate finish line. And the persistence in wage inflation implies that deposit rates will either be brought higher than generally expected or that deposit rates will be maintained at the terminal level for longer than expected.
While the coming Fed meeting leaves little room for surprise. The March and June meeting could see two additional 25 basis points hike (i.e. more than what is priced today). Likewise in the Euro Area, the risk of short-term interest rates is tilted on the upside.
Conversely, yields on longer-term maturities could move lower. Indeed they have regained their protective value, with real interest rates being back in positive territories, and an increasing amount of good news being factored in.
Christian Scherrmann, US Economist at DWS
In December the Federal Open Market Committee cut its pace of rate rises to 50bps from 75 basis points, while insisting on the continuing need for much tighter monetary policy. In February a repeat of the same move looks on the cards: the Fed is likely to reduce its rate rise to 25 basis points this time but will still insist that policy is going to tighten. To see the smaller rise in rates as a dovish pivot would be to misread the cards the Fed is playing.
There are still plenty of reasons why the Fed must stay hawkish despite some progress in reducing inflation, with the sixth consecutive monthly fall in CPI inflation in December, to 6.5 percent. Above all, labor markets remain stubbornly robust. The unemployment rate declined back to a post-pandemic low of 3.5 percent in December as an influx of labor was more than matched by strong demand for workers. This means that wage growth remains high, though there has been some welcome loss of momentum. The Fed seems to expect the robust labor market to persist in the short term – even though economic momentum is expected to cool further, and the first lay-offs are being communicated by large firms.
The magic formula for FOMC members, therefore, remains to increase rates to “somewhere above 5 percent” in order to be “sufficiently restrictive”. With the benchmark policy rate currently at 4.25 – 4.50 percent, this seems to be within arm’s reach. The chief task of Fed Chair Jay Powell in the upcoming meeting that concludes on February 1st is therefore to convince markets that rates will remain high for a prolonged period – something Fed officials have mentioned frequently. And this is the point where markets are not accepting the Fed’s argument. Currently, the markets do foresee a terminal rate of close to 5 percent but then the price-in rate cuts as soon as mid-2023.
This could well mean that the upcoming meeting will generate market disappointment. Fed officials have already flagged the fact that they feel misunderstood. The December 2022 FOMC meeting minutes reveal that the Fed sees a misperception of its reaction function as something that could complicate its efforts to restore price stability. And the Fed has pointed to the huge gap between its projections for rates and the current market pricing. Indeed, financial conditions have become still more accommodative since the December meeting. Therefore, though the market’s expectations of a 25 basis point hike in the upcoming meeting are rock solid, there is some slight possibility that the Fed will surprise with a 50 basis point hike.
Overall, it would seem that there are two conflicting views of how the economy will evolve on the table. On the one side, the Fed foresees a soft landing (with an increased risk of a mild recession), enabling it to keep rates higher for longer. On the other side, markets are pricing in a more severe economic downturn, forcing the Fed to bring down rates quickly. We remain in the middle ground. We expect a mild recession that should not provoke a big rise in unemployment. In part because of this, inflationary pressures are likely to prove persistent, meaning that the Fed will continue to fight inflation through 2023. It will therefore keep rates high, and not be quick to reduce them.
François Rimeu, estratega senior de La Française AM
We expect that the Federal Open Market Committee (FOMC) will slow down hike rates from 50 basis points (bps) to 25 bps at its February meeting.
The FOMC to hike rates by 25 bps to a range of 4.50%-4.75%. Fed Chair Powell will reiterate the Fed’s commitment to restore price stability despite the deceleration in the pace of rate increases. He will reaffirm that rates will probably need to go higher (i.e., for a peak within a range of 5.00%-5.25% by the end of 2023 according to the policymakers’ last median forecast). Chair Powell will also reiterate that the Fed will keep rates high until “the job is done” (i.e., bringing down inflation to the 2% target).
We expect Jerome Powell to keep the door open for a pause in rate hikes at the March meeting subject to the outlooks on both inflation and real economic activity. He might underlign that over the last 3 months, the annualized inflation rate has been in line with their objective, which is obviously good news.
As Fed Vice Chair Lael Brainard recently said, “the FOMC moved policy into restrictive territory at a rapid pace, this will enable us to assess more data as we move the policy rate closer to a sufficiently restrictive level, taking into account the risks around our dual-mandate goals”.
The Fed will continue its quantitative tightening ($95bn/month since September 2022).
In summary, we expect the Fed to try to keep flexibility and optionality open as monetary policy moves to a more restrictive stance. At this committee, we believe risks are on the dovish side with U.S. interest rates lower.
Thomas Hempell, head of macro and market research at Generali Investments
Amid a dense week of central bank meetings, be prepared for mounting rifts over the policy outlook. We expect the hawks to still prevail – for now.
As the Fed will hike by only 25bp, the focus will shift to the number of remaining like-sized hikes. The Fed’s Dec. dots suggest further moves in both March and May. Markets, cheered by moderating inflation and weaker leading indicators, don’t buy this any longer. Dovish FOMC members are stressing more eagerly the Fed’s dual mandate (inflation and employment). Ultimately, though, led by Chair Powell, the FOMC is still likely to lean towards a steady approach to inflation-fighting as fin. conditions have recently eased. So expect the outlook language of “ongoing increases” (plural) to be maintained in the statement.
Muzinich & Co
“There are sufficient signs for the Fed to justify slowing the pace of tightening to 25 basis points at its next meeting.” Among these signs, they point to some macro data, such as “the Producer Price Index, whose month-on-month fall of 0.5% was the most outstanding economic data for the United States, and the Consumer Price Index (CPI) and wages” and others related to the corporate bond markets, which, according to the fund manager, “continued to see rises in their prices, with a 0.5% month-on-month fall, according to the manager, “continued to see price rises, driven by strong technical data, and we saw defensive positions unwind through high cash balances and higher inflows into the asset class so far this year”.
Muzinich & Co also comments that “there are signs that near-term inflation fears are diminishing,” noting, among them, “the slight decline in government bond yields, with the U.S. curve steepening.”
Tiffany Wilding, North American Economist, and Allison Boxer, Economist, at PIMCO
Important week with Federal Open Market Committee (FOMC) and payrolls. We expect to see some temporary drivers behind another solid payroll report, while wage inflation data will be closely watched for gauging the Fed outlook. At Wednesday’s FOMC meeting we expect the Fed to slow the pace of rate hikes to 25 basis points (bps), while Powell uses the press conference to signal that the inflation fight is not yet over.
This Week: The Fed releases a new FOMC statement at 2pm EST on Wednesday. No dot plot or economic projections at this meeting. We expect the Fed to slow the pace of rate hikes to 25 bps, a modestly dovish statement changes, and a relatively hawkish press conference from Chair Powell.
Economic Data: The Employment Cost Index (ECI) will be in focus ahead of FOMC. We see downside risks to consensus expectations (0.9% vs. 1.1% consensus), which would be very welcome news for Fed officials concerned about underlying inflationary pressures. We think the Fed will be closely watching this report for further signs that wage inflation may have peaked.
We see temporary reasons for another solid employment report – we’re looking for somewhat above consensus 225k payroll gains, in line with last month’s pace. Our forecast would see the unemployment rate (3.5%) and average hourly earnings (0.3% m/m) both unchanged.