Interest Rates In 2023, Will A Recession Force The Fed To Cut?

The Fed will meet to set short-term interest rates on May 3. Wall Street currently expects the Fed sees a balanced chance of the Fed either making a 0.25-percentage-point hike or holding rates steady. The Fed likely wouldn’t disagree with that assessment, but is waiting to assess incoming data.

However, the bigger question is what happens for the remainder of 2023. The Fed expects to hold rates at elevated levels for the rest of the year. However, markets estimate that the Fed may cut rates by September, based on economic weakness. The Fed meets eight times a year to set rates, so there is no meeting for April.

Recession Signals

So the big question that is likely to drive interest rates for 2023 is whether we see a U.S. recession. Many indicators imply that a U.S. recession could be on the horizon. The yield curve is inverted, that has historically forecast recessions with some accuracy. House prices are softening, and housing is a key swing sector for the economy. Yet, in contrast, unemployment is at very low levels, implying no recession yet, but did edge up in February to 3.6% as corporate layoffs continue especially in tech, though many sectors including notably leisure and hospitality, continue to add jobs.

If we do see a recession, it may help bring down inflation. That could enable the Fed to ease back on rates. However, for now the Fed is stressing that its goal is to bring down inflation, and it doesn’t see economic weakness.

Banking Crisis

The economic impact of the recent banking crisis is also a wildcard for rates and the economy. The Fed believes that the disruption to banks has served to reduce lending, which may have done some of the Fed’s work by helping cool the economy and inflation. However, in turn, the banking crisis could raise recession risks.

Incoming Data

Data leading up to the Fed’s May meeting will prove decisive. Of course, inflation will take center stage, with the main question being trends in shelter costs. Housing inflation remains elevated in CPI data, but industry data suggests home prices are falling. This is due to a lag in how CPI housing costs are calculated. At some point housing costs in the CPI series will ease, but we haven’t seen that yet. However, beyond inflation is the broader economic picture. So far that hasn’t weakened enough to put pressure on the Fed to cut rates, but with the recent nudge up in unemployment and the banking crisis, risks are increasing.

What To Look For

We are likely close to the top of the interest rate cycle. The Fed will likely nudge up rates in May or hold them steady depending on how economic data trends over the coming weeks. However, the bigger question is whether the Fed will be forced to cut rates later in 2023. Currently, markets see this as probable, but the Fed expects to maintain high rates for some time.