Unpacking A Big Macro Week
On the inflation front, data showed U.S. consumer price inflation eased more than expected in November. Consumer prices rose +7.1% y/y, down from October's +7.7% y/y pace and the slowest annualized pace since December 2021. Core CPI, which excludes volatile energy and food prices, rose +6% y/y, down from October's +6.3% y/y pace. Price increases also slowed on a month-to-month basis, rising +0.1% m/m during November after a +0.4% m/m increase during both September and October. Looking at the category level, Energy and Goods prices continued to decline, while Services prices continued to rise. The report provided further evidence that inflation pressures are easing, but the key question is where inflation settles and whether it reverses higher.
Last week, the Federal Reserve increased the fed funds rate +0.50% to a targeted range between 4.25%and 4.5%, breaking a string of four consecutive +0.75% rate hikes. The new range marks the highest fed funds rate in 15 years, an indication the Fed is committed to fighting inflation and will continue to raise interest rates until it is under control. Markets widely anticipated the step down to +0.50%, and Fed Chair Powell suggested the central bank could step down again to a traditional +0.25% rate hike at its next meeting at the end of January 2023.
The Fed's updated Summary of Economic Projections (SEP) was notable. Since the September meeting, the Fed has increased the projected fed funds rate for both 2023 (up to 5.1% from 4.6%) and 2024 (up to 4.1% from 3.9%). The Fed is being very explicit: it expects to raise interest rates deeper into restrictive territory and keep them there for longer with no cuts until 2024. The market, however, views the Fed as highly uncredible. Figure 1 shows investor expectations differ drastically: the market expects a 4.8% peak fed funds rate (vs Fed's 5.1%), rate cuts during 2023, a 2023 year end 4.6% rate (vs Fed's 5.1%), and more rate cuts during 2024 with a year end 3.2% rate (vs Fed's 4.1%).
Moving on to the economic portion of the SEP, the Fed made the following changes since the September meeting: decreased real GDP estimates for both 2023 and 2024; increased 2023 unemployment rate estimate; and increased 2023 Core PCE inflation estimate. The changes in estimate show the Fed expects its interest rate hikes to slow the economy next year and increase the unemployment rate, as it takes longer for inflation to return to 2%. However, the weaker outlook and downward revisions still indicate the Fed believes it can achieve a soft landing. It will be a delicate balancing act for the Fed to pull off, but that path is still on the table.
The Fed's hawkish message highlights the delicate balance between data dependency and narrative. While inflation trends appear to be heading in the right direction, and the economy remains mostly resilient, the risk of shifting to a dovish tone is that the expectation of looser financial conditions could lead to a revamp of economic activity that pushes inflation back up. As we saw in the '70s (Figure 2), encouraging inflation trends don't always hold. More importantly in our view, whether the current trend holds or not, inflation is historically slow to correct back to historic norms. In light of that, we remain steadfast in our commitment to further diversifying portfolios and increasing exposure to assets classes that can benefit if inflation remains stickier. This focus on the total portfolio should allow for success regardless of where the market goes next.
