Key takeaways

  • The U.S. Federal Reserve (Fed) increased interest rates by 0.25% to a range of 4.50% to 4.75% today, after multiple 0.75% and 0.50% hikes, in its ongoing attempt to cool inflation.

  • Chairman Jerome Powell indicated future rate hikes may remain necessary, and rate cuts this year remain unlikely despite decelerating inflation.

  • Investors expect decelerating inflation to allow the Fed to halt rate hikes by mid-2023 near 5% before cutting rates later in 2023, in stark contrast to Fed guidance.

The Federal Reserve increased its target federal funds interest rate by 0.25% to a range of 4.50% to 4.75% and noted “… ongoing rate increases will be appropriate,” following the conclusion of its regularly scheduled two-day meeting. Interest rate policy represents the primary tool the Fed uses to carry out its mandates of maximum employment, stable prices and moderate long-term interest rates.

Inflation recently slowed from a 40-year high above 9% to 6.5%. Despite rapidly decelerating inflation, ongoing price gains above Fed target levels continue to drive Fed tightening. Tight labor markets and robust wage growth add to Fed concerns that inflation may remain stuck at a high rate. Today’s 0.25% increase represents a return to a more normal change after a string of 0.75% and 0.50% increases lifted the funds rate from a range of 0% to 0.25% one year ago.

Investors focused on Fed Chairman Jerome Powell’s tone at the press conference after the meeting, considering there was no update to the Fed’s Summary of Economic Projections (SEP), an every-other-meeting forecast compendium. The first and arguably most important question Powell received related to financial conditions, which have eased considerably in recent months and could undermine the intent of recent policy tightening. Many anticipated a strong pushback on recent market exuberance, but instead Powell repeated past comments that the Fed “does not focus on short-term changes but on sustained changes to broader financial conditions.” Investors perceived this reply to indicate buying stocks and other risky assets may not prompt the Fed to tighten policy more aggressively. Stock prices rose and bond yields fell following Powell’s response. He reiterated future interest rate decisions will depend on economic data, but “the job is not fully done” and “restoring price stability will require maintaining a restrictive stance for some time.”

The Fed remains in the early stages of reducing its Treasury and mortgage bond holdings, which reached as much as $8.5 trillion during its attempt to suppress interest rates in response to the COVID pandemic. In addition to restraining post-pandemic bond yields and encouraging borrowing, the Fed’s bond buying also converted bonds held by investors to cash, which can support economic activity through added liquidity. Starting last year, the Fed began allowing up to $95 billion per month to mature, forcing investors to absorb the incremental supply. Thus far, the relatively small balance sheet decline has not disrupted market functioning or contributed to higher yields. However, the chance remains for bond portfolio runoff to nudge bond yields higher (which move in the opposite direction of bond prices) and dampen liquidity, in turn reducing a portion of the fuel available for future economic growth. The U.S. Treasury spending down its cash balances at the Fed without issuing more debt, to avoid exceeding the debt ceiling, may temporarily offset the liquidity drained from the financial system via Fed bond portfolio runoff.

Stock prices jumped and bond yields fell after Powell’s soft response to a question about easing financial conditions. The S&P 500 finished up 1.1%. Ten-year Treasury yields fell 0.09% to 3.41% (well below 2022 highs near 4.25%). The two-year Treasury yield fell 0.10% to near 4.11% and remains below 2022 highs near 4.75%. Lower bond yields and interest rates reflect lower borrowing costs, which can fuel economic activity.

Monetary policy, defined as central bank interest rate target decisions, continues tightening around the globe as high food and energy prices begin spilling over into prices of other items, particularly services. Investors expect the European Central Bank (ECB) and Bank of England (BoE) to increase their respective policy rates this week by 0.50% each. Net global rate hikes (the number of central banks raising interest rates less those lowering rates) set consecutive quarterly records for magnitude and count during the first three quarters, with fourth quarter net hikes decelerating only slightly. We anticipate a turning point in 2023, with first quarter net hikes likely to be a fraction of quarterly hikes in 2022 as inflation falls. In addition to ongoing policy tightening and tighter liquidity noted earlier, consensus expectations indicate subdued global growth for upcoming quarters. Recent purchasing manager surveys affirm weak global growth estimates but indicate increasing divergences by country and region.

Capital markets have been strong to start the year following a more challenging 2022. Today’s Federal Reserve decisions and a seemingly softer stance on prospective inflation may provide investors with some level of relative comfort, but some of our proprietary analysis suggests that the path forward for consumer activity and corporate earnings may be more challenging than current prices suggest. We do expect capital markets to oscillate between cheering lower inflation and reflecting concerns about potential slowdowns in consumer activity. We will keep you posted on our views as we progress forward into 2023.

As always, we value your trust and are here to help in any way we can. Please do not hesitate to let us know if we can help address your unique financial situation or be of assistance.

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This information represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are current as of the date indicated on the materials. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not affiliated or associated with any organizations mentioned.

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