Federal Reserve expected to slow pace of interest rate hikes to kick off 2023

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The Federal Reserve will kick off its first policy meeting of the year Tuesday, with investors expecting Wednesday’s policy statement to show interest rates rise at a slower rate for the second-straight meeting.

Markets are pricing in a nearly 100% chance the Fed raises its benchmark interest rate by 25 basis points on Wednesday, a move that would bring the policy rate to a range of 4.5%-4.75%.

A chorus of Fed officials have signaled a quarter-point rate hike will be announced on Wednesday, which would mark a further slowdown from the half percentage point hike announced in December.

Before December’s announcement, the Fed had raised rates by 0.75% at each of its prior four meetings.

The Fed will announce its latest policy decision at 2:00 p.m. ET on Wednesday, with Fed Chair Jerome Powell set to hold a press conference at 2:30 p.m. ET. The Fed will not offer updated economic forecasts on Wednesday.

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“There appears to be little turbulence ahead, so I currently favor a 25-basis point increase at the FOMC’s next meeting at the end of this month,” Fed Governor Chris Waller said earlier this month.Philadelphia Fed President Patrick Harker said: “[In] my view, hikes of 25 basis points will be appropriate going forward.”

Both Boston Fed President Susan Collins and Dallas Fed President Lorie Logan said earlier this month they favor raising rates at a slower pace, but didn’t outright identify 25 basis points as the magnitude of the needed rate increase. Logan will serve as a voting member of the Federal Open Market Committee — the Fed committee that votes on monetary policy — for the first time this week.

Federal Reserve Board Chairman Jerome Powell speaks during a news conference following the announcement that the Federal Reserve raised interest rates by half a percentage point, at the Federal Reserve Building in Washington, U.S., December 14, 2022. REUTERS/Evelyn Hockstein

Expectations rate hikes will slow down come as inflation has shown some signs of easing, though price increases remain well above the Fed’s 2% target.

The Fed’s preferred measure of inflation, the personal consumption expenditures index excluding food and energy, increased 4.4% in December from a year ago, down from a 4.7% reading in November and marking the slowest annual rate of increase since October 2021.

Meanwhile, the “core” consumer price index, which excludes food and energy prices, inched up 0.3% in December, after rising 0.2% in November. Year-over-year, core CPI rose 5.7% in December, down from the 6% pace seen in November.

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“Fed Chair Powell will need to acknowledge encouraging inflation data that’s come in,” said Wilmington Trust chief economist Luke Tilley. “This is not a one off. We have had had three months of encouraging data.”

Tilley thinks despite encouraging inflation data, the Fed will use hawkish language on Wednesday because officials don’t want financial conditions to loosen too much and are still watching wages. “Powell wants to stay the course and do no harm,” he said.

Rising stock prices and moderating interest rates have resulted in financial conditions easing significantly since peaking in October.

Wilmer Stith, bond portfolio manager for Wilmington Trust, said he doesn’t expect the Fed to bring up pausing rates this week given the loosening in financial conditions. “I think the Fed will hold through end of the year and not cut [rates] to ensure tighter financial conditions,” said Stith.

The economy has also showed signs of slowing with consumer spending slowing in the fourth quarter while businesses cut back their spending on equipment. In recent weeks, new data have shown a drop in manufacturing activity, weaker retail sales, and layoffs spreading beyond the technology sector.

Investors will also be looking for clues on how much more the Fed’s benchmark rate will rise. And when the Fed could pause rate hikes altogether.

“There could be one last hawkish sting in the tail,” said Paul Ashworth, chief U.S. economist at Capital Economics. “We expect [Wednesday’s] statement to maintain the language that ‘ongoing increases’ (emphasis on the plural) in rates will be required and, to counter the recent easing in financial conditions, forward guidance could be added that commits to leaving rates at elevated levels for some time.”

Most Fed officials estimated in December the policy rate would rise to a peak between 5% and 5.25%, implying two more quarter-point increases.

Officials have said they don’t want to make the mistake of not raising rates enough, resulting in a resurgence of inflation pressures in the economy.

‘Even after we have enough evidence to pause rate increases, we’ll need to remain flexible and raise rates further if changes in the economic outlook or financial conditions call for it,” said Dallas Fed President Lorie Logan in a recent speech.

Tilley, like other market participants, believes inflation and the economy are slowing faster than the Fed thinks and expects a rate cut in the fourth quarter.

“Even if they cut rates, they still have on the brakes. They’d just be letting up a bit,” Tilley said. “If they keep the Fed Funds Rate at 5% and inflation is dropping, then on an inflation adjusted basis the Fed is passively tightening at that point.”

From a risk management perspective, however, Fed officials see the central bank needing to protect against inflation taking back off, noting that in 2021 there was a drop in core inflation for three straight months before jumping back up.

“We do not want to be head-faked,” Waller said. “But if we’re wrong and inflation comes down more rapidly than thought then it’s easier to cut rates.”

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