Bonds

Fed outlook 2023: Rate cuts in 2023 or 2024?

The Federal Open Market Committee may cut rates next year, according to some analysts, while others expect no declines until 2024.

“I think the market is right in terms of projecting cuts later next year because I do think we’ll see both a combination of a weaker labor market and higher unemployment and softer inflation,” Steven Friedman, macro economist and managing director at MacKay Shields LLC, said in a recent Bond Buyers Leaders presentation. “So that then does allow the Fed to pivot towards rate cuts towards the end of next year.”

Next year will be a transition, said Kelly Bogdanova, vice president and portfolio analyst at RBC Wealth Management, with “rates rising somewhat further in the first half before falling in the second.” With inflation still well above the Fed’s 2% target, officials have “made a point of emphasizing the dangers of cutting rates too soon.”

“Outright rate cutting is unlikely to be on the table, in our view, until there is some marked worsening in the economic data, particularly on the employment front,” said Kelly Bogdanova, vice president and portfolio analyst at RBC Wealth Management.

However, if inflation eases, it could allow the Fed to pause, she said. “However, outright rate cutting is unlikely to be on the table, in our view, until there is some marked worsening in the economic data, particularly on the employment front.”

That could be later next year. RBC expects recession by midyear, which could be a path for the Fed to cut rates “to soften the impact,” she said.

“The Fed’s task for next year will be to calibrate the stance of policy by moving the funds rate less frequently and in smaller increments,” said Ryan Swift, U.S. bond strategist at BCA Research. “Both rate hikes and rate cuts will be on the table in 2023, with the Fed’s overarching goal being to achieve the fabled soft (or softish) landing for the U.S. economy.”

The Fed will likely pause after its March meeting “when monetary policy is sufficiently restrictive.”

Should core inflation drop to 3.5% and unemployment grow to 4.6% next year, as the Fed predicts, he said, “the Fed will likely cut rates in H2 2023 if this economic scenario plays out.” Swift sees “high odds” of a second half rate cut because if rates aren’t “sufficiently restrictive” yet, “they will be deemed so very soon.”

Below trend economic growth, falling core inflation rates and fewer job vacancies should continue for the next quarter or two, he added. The Fed will raise rates by a quarter point at its next two meetings before pausing.

“In our view, the Fed’s current rhetoric is overly hawkish because strategically it wants to ensure that long-dated inflation expectations remain well-anchored near its target as it downshifts the pace of tightening and prepares for a pause,” Swift said. “From a risk/reward standpoint, there is currently little downside to this communication strategy, especially since market prices appear to be doubting either the Fed’s hawkish resolve, its 2023 economic outlook, or some combination of the two.”

Tom Garretson, fixed income senior portfolio strategist at RBC Wealth Management, expects “a series of modest rate cuts over the course of the back half of 2023.”

But others expect rates won’t be lowered until 2024.

“We take the Fed at their word and have aligned our short-term interest rate forecasts with the Fed’s median view,” said Scott Anderson, chief economist at Bank of the West. “We envision 25 basis points hikes at each of the next three FOMC meetings in February, March, and May, even as the economy enters a shallow recession with net job losses.”

In additions to expecting rate hikes later than what the market expects, he added, “We also do not see any scope for Fed rate cuts until the end of Q1 2024, while the futures market expects about 50 basis points of rate cuts in the second half of 2023.”

The market’s expectations, Anderson said, are “more hope than anything.”

Inflation will prevent the Fed from moving aggressively to halt a recession, he said. “The difference with the impending recession to what investors might have seen in the recent past is that policy makers will be reluctant to run to the rescue of the markets with consumer price inflation where it is today. The Fed remains squarely focused on their inflation mandate and will largely ignore rising unemployment or even mild financial instability to obtain their 2% inflation goal.”

At some point the dual mandate will force the Fed to make a decision, according to Wells Fargo Securities Chief Economist Jay Bryson, Senior Economist Sarah House, International Economist Brendan McKenna and Economist Charlie Dougherty.

“We believe policymakers will continue to come down on the side of bringing inflation back toward the Committee’s target of 2% at the expense of allowing the unemployment rate to rise,” they said in a report. They expect the Fed will raise the target to a range of 5% to 5.25% by March.

“The risks appear to be skewed toward slightly more tightening rather than slightly less relative to our base-case view,” they said. Wells Fargo sees rates staying at that level until early 2024.

Rate cuts next year are “a highly unlikely prospect,” said Robert Bayston, head of U.S. government and mortgage portfolios at Insight Investment. “The Fed has still not seen any significant success in loosening the labor market across the economy, despite tech sector layoffs dominating the headlines,” he noted. “Therefore, it is difficult to see any justification for policy easing anytime soon, absent a severe and unexpected deterioration in the economy.”

While a soft landing is still possible, Bayston said, “it will be a difficult needle to thread for the Fed. Labor market conditions will need to cool enough to temper wage growth, but not too much that aggregate job losses result in a negative feedback loop that leads to a recession.”

Should there be a recession, he added, it “would be relatively shallow.”

A mild recession wouldn’t surprise KC Mathews, chief investment officer at UMB Bank.

“In 2023, the Federal Reserve will continue to battle inflation and hike rates reaching its terminal rate in the first half of the year, while inflation slowly dissipates,” he said. “This will cause economic activity to slow, perhaps to a recession-like pace, causing financial markets to be choppy, yet producing positive returns.”

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