Throughout 2022, U.S. economic growth held on reasonably well overall, given how much inflation increased which forced the Federal Reserve to hike interest rates higher than anyone—even the Fed itself—expected. Now as we look forward through the first quarter of 2023, inflation again will be the key, as it will determine what the Fed does and, in turn, how the economy—including your investments—fares.
The most recent figures have been promising in the sense that inflation cooled more than expected. Year-over-year, prices were up 7.1% in November, down from 7.7% in October, according to the Consumer Price Index (CPI). This data, released Dec. 13, is of course lagging, so time will tell how high inflation was in the last month of the year.
Just how much has the Fed hiked rates?
On Dec. 14, the Federal Open Market Committee (FOMC) increased the Federal Funds rate by half a percentage point to a target range of 4.25-4.5%. To put this figure in perspective, in January 2022, the target range was 0-0.25%.
Looking forward, it’s important to remember that monetary policy, too, operates with a lag. We have yet to feel the full brunt of the rate hikes in 2022—and the Fed isn’t done yet. On Feb. 1, the Federal Open Market Committee (FOMC) is expected to increase the Federal Funds rate by another 25 to 50 basis points (one-quarter to one-half of a percentage point), and the interest rates that consumers and businesses pay on debt will follow suit.
What happens after that will likely play out in one of two scenarios.
The good news scenario
If overall inflation continues to trend down and the labor market rebalances, that likely would be a green light for the Fed to stop raising rates—that is, after the rate hikes that are already anticipated for February and March. After March, the Fed would hold rates near 5% for much of the year. On the downside, this labor market rebalancing means that the unemployment rate would rise, but that rise is part of the Fed’s purposeful slowing of the economy in order to combat inflation. On the upside, not only would prices be coming down in this scenario, the country’s gross domestic product (GDP) growth in the quarter would be positive—at least somewhat, at below 1%. This scenario would also mean an above-average year for bond investments and a fine outcome for stocks, too, although they still might have a below-average year.
This “good news” scenario is slightly the more likely option of the two for several reasons. First, November’s CPI headline rate marked the fifth-straight monthly decline, so inflation does seem to be moving in the right direction. Goods prices in particular are coming down, and even rent prices, which have been persistently high, are moving down some.
In summary, in order for this scenario to happen, the U.S. economy needs to slow enough to bring down demand and, in turn, prices. We’re starting to see signs of slowdown in the manufacturing sector already. For instance, ISM Manufacturing PMI declined to 49 in November; less than 50 is considered a contraction—that is, a period when economic output declines. The Chicago Purchasing Managers Index, the Dallas Fed Manufacturing Index and the Philly Fed Manufacturing index are all at their lowest levels since 2020, reflecting a slowdown in manufacturing in multiple geographic regions of the U.S.
However, the services side of the economy, which makes up the lion’s share of it, continues to expand. That’s largely due to the strong labor market, which needs to cool in order for this “good news” scenario to take place.
The bad news scenario
If inflation doesn’t trend down significantly in the first quarter, that would force the Fed to hike rates even more than the 5% range they are currently guiding toward. These additional rate hikes would cement the odds for a recession in the mid-year. Although this scenario is less likely to happen than the first, the difference in probability is marginal.
If this “bad news” option does occur, it would impact both your stock and bond investments. The “harder” the economic landing, or recession, the more the Fed would have to reverse course and actually cut rates, which would be good for bonds, especially longer-term bonds with high credit quality. However, it would be bad for equities, which could be down double digits again.
The bottom line
I can’t say it enough: it all comes down to inflation. Inflation will determine the Fed’s actions, which will determine what happens for the U.S. economy.
But amidst this uncertainty, there are still some economic upsides. Consumers still have an estimated $1.2 trillion in excess savings that they accumulated during the pandemic. Those savings can fuel increased spending and economic growth. In fact, they’re part of the reason the U.S. economy hung on as well as it did in 2022, despite decades-high inflation levels.
Yet not everyone has had the ability to hang on this well in the face of high prices at the grocery store and gas pump, as well as high bills at home. Rather, these excess savings are likely being held by wealthy consumers—not middle- and lower-income consumers, who have been struggling and accumulating more and more credit card debt to make ends meet.
That’s why it’s so important for the Fed to slow the economy to bring inflation down.