How High Could U.S. Interest Rates Rise In 2023?

Markets now view it as likely that the Fed Funds rate reaches 5.25% to 5.50% in 2023. There’s even an slim chance that rates touch 6%, but it’s much less likely. The reason is that although we are likely past peak inflation rates, certain prices continue to rise suggesting that more work is needed for inflation to hit the Federal Reserve’s 2% goal. This concern has also put pressure on equity markets in recent weeks.

Further Hikes

The Fed is now expected to hike rates at upcoming meetings in March, May and June according to interest rate futures. As Fed Governor Christopher Waller said on February 8, “inflation remains quite elevated, and so more needs to be done”. Further hikes beyond June are possible, as is the Fed making a larger 0.5% percentage point move at an upcoming meeting.

This is not a wholesale shift from expectations at the end of 2022, the Fed is still expected to be close to the top of its interest rate cycle. However, whereas previously it was debated whether rates would exceed 5%, that is now viewed as almost a given. The question now is where in the 5% to 6% range rates will end up.

Stubborn Inflation Data

The main reason for this change in market expectations is that although inflation is trending down, it is not trending down as fast as the Fed wants. The jobs market and economic growth appear to be holding up better than most expected, that has the potential to put further upward pressure on prices in the Fed’s view. For example, the Atlanta Fed’s Wage Growth Tracker, had wages rising at a 6.1% annual rate in January, that’s down from recent highs, but not by much. The Fed’s goal is a 2% annual inflation rate, and the Fed is worried that we aren’t on track to get there just yet.

Lagged Effects

Part of the challenge for the Fed is the lagged effects of monetary policy. It’s generally thought that the restrictive effects of higher interest rates aren’t fully felt by the economy until around a year later. The Fed believes that rates are restrictive today, and is now fine-tuning interest rates as economic data comes in. For now, that fine tuning appears to involve slightly higher rates.

Nonetheless, we’ve recently seen 0.25% percentage point hikes, which are a lot smaller than the 0.75% percentage point hikes that we saw for much of the second half of 2022. Markets expect smaller moves in interest rates to continue for the first half of 2023.

What’s Next?

The Fed’s meeting on March 22 will be instructive in helping the markets adjust their rate interest rate expectations for 2023. Part of the reason for this is that the Fed will release a Summary of Economic Projections, updating its December 2022 forecasts for where rates will end up this year.

That will help markets and the Fed get on the same page. Despite this, the Fed’s policy makers have divergent views and the Fed themselves typically forecast a range of outcomes for interest rates in their projections. Still now the consensus view is that the Fed has more work to do in moving up rates and hikes could continue at least until the Fed’s June meeting, possibly even beyond.