In its first meeting of 2023, the U.S. Federal Reserve announced a 25 basis point interest rate increase. This raises the federal funds rate – which affects long-term interest rates in both the U.S. and Canada – to a target range of 4.5 to 4.75% – the highest it’s been since 2007. It was the Fed’s eighth consecutive rate increase, but the smallest since last March.
Inflation rose 6.5% year-over-year in December, a slowdown from the 7.1% increase in November. While inflation shows signs of cooling, the Fed stated that it remains “strongly committed” to reaching its 2% inflation target and signaled that more interest rate increases may be coming. (Interest rate hikes are intended to reduce inflation by making it more expensive to borrow.) The state of the employment sector is a significant factor in the Fed’s decision-making process, and the labour market remains strong.
Employers added 517,000 jobs in January. The surge in hiring was spread across most industries, and the jobless rate fell to a 53-year low of 3.4%. While average hourly earnings continued to moderate, rising 0.3%, aggregate works hours were up 1.2% in the month. With these kinds of numbers, it is hard to see how the U.S. is slipping into a recession.
Investors and the Fed disagree on the direction of interest rates in 2023
Currently, there is a disconnect between the Fed’s perspective and the market view on where interest rates may be headed this year. While the Fed has stated its intention to keep rates elevated for as long as it takes to bring down inflation, the market has started to anticipate a pause and potential cut in rates. This suggests that investors either believe that a recession is expected and the Fed will need to start cutting rates this year to stimulate the economy, or that inflation will decline quickly during the year and there will be no need to raise rates any further.
The general expectation is for inflation to fall fast this year – the question is whether it will stay above the 2% target. The Personal Consumption Expenditures Price Index (PCEPI) – the core inflation measure the Fed follows – is tracking above policy targets. For that reason, most members of the Federal Open Market Committee (FOMC) – the branch of the Fed that determines the direction of monetary policy in the U.S. – are expecting that the fed funds target ranges would need to be raised to above 5% this year.
The Fed’s next interest rate announcement is scheduled for March 22.
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