Fed Sees Further Hikes In 2023, Here’s What Could Change That

At the December 2022 interest rate announcement, Fed Chair Jerome Powell struck a hawkish tone on the dangers of entrenched inflation. Rates increased 0.5 percentage-points with more hikes likely when the Fed announces rates again on Feb 1 and March 22, 2023.

However, inflation has fallen over recent CPI reports, so what would make the Fed change course and lower rates? The answer according to Powell’s press conference on December 14, 2022 more subdued wage growth, paired with additional evidence that inflation really is beaten.

Recent Inflation Data Trends Lower

Since July 2022, month-on-month inflation has trended lower than earlier in 2022. Despite this decline, annual inflation is still 7.1% for November, and that some of the recent inflation decline is due to falling energy costs.

However, the monthly data does suggest that inflation is trending lower. It’s been insufficient for the Fed so far.

U.S Month-on-Month CPI Inflation, 2022

Risk Management

The first concern the Fed has is basically risk management. They want to be sure inflation is contained before they dial back on rates since price stability in Powell’s view is the “bedrock of the economy.” At the moment, Powell noted that the Fed, “continue to see risks to inflation as weighted to the upside.”. If the Fed does not aggressively fight inflation now, then coming back and raising rates again could lead to even more pain for the economy. In addition, it could cause longer term inflation expectations to rise, or become ‘unanchored’ in the Fed’s terminology. Inflation expectations have so far remained relatively subdued, but the Fed is watches closely.

That’s why the Fed has downplayed a few months of encouraging inflation data. Also, the Fed’s goal is 2% inflation and not falling inflation, as a result the Fed wants to be sure that inflation will continue to move lower and won’t remain stuck at around say 4% or 5%.

Cost of Goods And Housing Expected To Decline

There is good news. The Fed recognizes that the price of goods are generally falling, Powell noted at the December interest rate announcement press conference that, “goods inflation has turned pretty quickly”.

In addition, housing costs will likely move lower in 2023. Powell noted, “By the middle of next year [2023], we should begin to see lower inflation from the housing services sector.” This is basically a statistical point. Changes in house prices take some time to work there way into CPI data, because of a calculation method that introduces a lag to current house prices of around 6 months.

Wage Pressure

The Fed worries about services inflation. Wage growth is relatively high, currently running at around 6% according to the Atlanta Fed’s wage-growth tracker. The Fed worries that unless wage growth cools, higher wages will continue to fuel service inflation. Powell noted that wages are, “well above what would be consistent with 2 percent inflation.”

Economic Weakness

Economic weakness could also prompt the Fed to lower rates. The Fed is not inclined to be drawn on hypotheticals about the U.S. economy, but it would be historically unusual for the Fed not to dial back on rates if the U.S. economy did enter a full-on recession. However, this likely then returns the focus to the job market, if wage growth continues to be high, then would be surprising to see the U.S. economy enter a recession.

What The Fed Is Looking For

The Fed is encouraged by the recent easing of U.S. inflation. That’s one reason why they are now moving to smaller interest rate hikes and see peak rates coming in 2023. However, the Fed wants to be certain that inflation is beaten before cutting rates. At the current level of inflation of over 7% on an annual basis, the Fed still has concerns. Prices for goods are falling, and falling house prices may be reflected in the inflation series soon.

However, the Fed would like to see service inflation move lower too before it has real confidence that U.S. inflation is under control and moving back to its 2% goal.

Part of the reason the Fed has the ability to be patient on inflation is that the jobs market is currently robust, if that changes and recession looms, as the yield curve suggests is probable, then the Fed may have a difficult trade-off to make. So ironically, the Fed’s views on inflation currently have as much to do with the jobs market and wage growth than the inflation data itself.