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Focus on central banks: what to expect from Fed in 2023?

This year, investors are expecting the Federal Reserve to be more cautious with its monetary policy. But will it?

At its December 2022 Federal Open Market Committee (FOMC) meeting, the Federal Reserve raised interest rates for the seventh straight time. This year, investors anticipate a more sluggish central bank.

Brief summary of 2022

Around Christmas in 2021, the Fed began shifting to a more inflation-hawkish position. Nevertheless, what was once “transitory” inflation quickly became permanent. By early 2022, it was evident that higher interest rates and a reduction in the Fed’s balance sheet were the only solutions for runaway prices.

Fortunately, there are more and more indications that inflation has peaked. The consumer price index (CPI), which reached a 40-year high in June above 9%, has been trending downward for five straight months.

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The Fed will perhaps finish raising interest rates in 2023 after slowing them down first. Nobody can predict how soon they will be able to achieve this or how much additional economic damage will follow along the road.

Labor market remains solid (for now)

The robust and historically tight labor market has been a pain in the side of the central bank, despite the Fed’s (finally) tiny triumphs in slowing the economy. When there are many more open positions than people seeking employment, salaries may increase, prolonging price increases.

Therefore, the Fed may remain “continually hawkish” at the beginning of 2023 with its “laser focus on the labor market,” according to Ross Mayfield, an investment strategy analyst at Baird.

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There are already signs of a slowing labor market: layoffs have surged, but hiring and resignations have decreased. The number of new jobs added each month has slowly shrunk, and continuous claims have risen to their highest level since February.

Weak economic growth

In updated economic forecasts released at its December meeting, the US Federal Reserve refrained from declaring a recession. Instead, Fed Chair Jerome Powell stated that he believes the nation can maintain “modest” growth and anticipates only a “modest” rise in unemployment, despite the Fed’s intentional attempts to slow down the economy to lower inflation.

The Fed’s forecast is still rather bleak, with a growth of only 0.5% expected next year and an increase in unemployment that would result in nearly 1.6 million more unemployed people by this time next year, all of which appear to be signs of a recession.

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According to the Fed, unemployment will increase from its current level of 3.7% to 4.6% in 2023 before essentially staying the same over the following two years.

Terminal rate projections

Based on the Fed’s consensus forecast from December, the main benchmark borrowing rate – the fed funds – would increase by another 0.75% in 2023, reaching a 17-year high of 5-5.25% from its current 4.25-4.5% level.

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The Fed’s predictions also showed a more significant likelihood that interest rates would increase even further than that. Five officials have a 5.25–5.5% peak goal range, sometimes known as the Fed’s “terminal rate,” pencilled in. Two more governors predict rates would increase to 5.5–5.75%, which would be the highest level since 2001.

Only two officials predict that rates will peak at a lower 4.75–5% range.

Even if the Fed’s most optimistic projections come true, it indicates that rate increases of little more than 1.25% are possible for 2023. That is far less restrictive than the 4.25% of tightening that Fed policymakers authorized in 2022 alone.

Final thoughts

The Fed’s tightening cycle will cause pain in the US economy, especially in the sectors sensitive to interest rates, such as housing or technologies. However, the biggest rate hikes are behind us, and the most important thing for the near future is how long rates stay at elevated levels and when the Fed begins to lose monetary policy. According to the official predictions, the terminal rate will likely stay heightened in 2023.

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