Market Minute

January 2023 – By Scott Rosenquist, CFA®

The calendar has turned but the issues concerning financial markets remain the same.  The Federal Reserve is on track to continue tightening financial conditions through interest rate increases and reducing the size of its balance sheet which became bloated when it stepped in to support the bond market during the pandemic. Inflation remains above the two percent target that the Federal Reserve continues to defend. Recent gauges of the economic activity show services and manufacturing are in contraction as rate hikes take hold to slow the economy. How much longer will the Fed maintain its restrictive policy stance?

The jumbo-sized rate hikes of .75% appear to be behind us and the Fed now looks to fine-tune policy as economic conditions weaken and inflation pressures ease. The debate is about where the Fed funds rate tops out which is currently 4.25-4.50% and how long it will stay there before interest rates are ultimately cut. Recent commentary from Federal Reserve officials is pushing back on the market’s notion that interest rates will be cut later this year. Forward guidance, another tool used by officials to reflect their intentions is becoming more common, and financial markets sometimes react to this. The message from the Fed is clear, they look to keep rates high and financial conditions tight until they see further evidence that inflation is coming down. It is worth noting the track record of recent Fed projections. In December of 2021, their projection was for three interest rate increases of .25% for 2022 but it went way above that with increases of 4.25% to cool the economy. They are now looking for a policy rate just above 5%.

Financial markets are not in agreement that the Federal Reserve can keep interest rates that high for the entire year. This tug-of-war between the Fed and market expectations will lead to continued volatility until there is more clarity on the path of inflation and the economy.

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