'We have more work to do.' — Fed Chair Jerome Powell

The Federal Reserve slowed rate increases at its latest meeting but signaled its hiking cycle isn’t over.

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Key Points

  • As expected, the Federal Open Market Committee (FOMC) increased the federal funds target rate range to 4.25% to 4.50%, a 0.50% increase.
  • Median projections from the committee members showed three potential hikes by the Fed in 2023. As for potential rate cuts, there were four projected in 2024 and four in 2025.
  • The Fed’s economic outlook showed a minor up tick in GDP for 2022, while 2023 GDP projections saw a material decrease from September estimates. Inflation expectations saw increases across the board for 2022, 2023 and 2024 projections. The committee’s GDP estimates also moved higher from 0.2% to 0.5% for the year, while the core PCE price index increased from 4.5% to 4.8%.

At their December meeting, Federal Open Market Committee (FOMC) members agreed to hike the fed funds rate by 0.50%, a downshift from the previous four 0.75% hikes. The latest hike raised the benchmark rate to a range of 4.25% to 4.50%. Market expectations started the week with a 74% probability of a 50-basis-point hike, so the Fed’s action wasn’t much of a surprise.

This week’s rate hike continued to highlight the committee’s plans to do what is necessary to tame inflation. “We have more work to do,” Fed Chair Jerome Powell said after the FOMC meeting. With December’s well-telegraphed move, one of the main focuses of this meeting was to define “sufficiently restrictive,” as parts of the market have been anticipating a pause or cuts to the committee’s benchmark rate over the next 12 months. The Fed’s last “Dot Plot” showed a median projection for the fed funds rate of 4.6% in 2023, implying a target range of 4.50% to 4.75% at the peak of the hiking cycle. Although communications suggest that there has been significant debate between Fed hawks and doves about how high rates should go and for how long, the median projection this week showed a material revision from September for 2023 (4.5% to 4.75%) to (5.0% to 5.25%), redefining “sufficiently restrictive.”

As for the economy, the Fed increased estimates for GDP growth in 2022 from 0.2% to 0.5%, which still sits well below the committee’s long-term estimate of 1.8%. The Fed increased inflation estimates from 4.5% to 4.8% in 2022, as recent rate hikes have yet to gain significant traction in taming inflation. Unemployment projections decreased from 3.8% to 3.7%, with projections for unemployment revised higher in 2023 and 2024 from 4.4% to 4.6%, as price pressures and slower economic growth are expected to continue to weigh on labor market conditions over the next couple of years.

Here are the committee’s December projections for GDP, unemployment, inflation, and the federal funds rate for 2022 through 2025:

Source: FOMC as of 12/14/22.

The committee’s “Dot Plot” contained noticeable changes in the projections for the fed funds rate in 2023, 2024 and 2025, all of which showed the fed funds rate higher. The committee’s benchmark rate was revised 50 bps higher in 2023, 25 bps higher in 2024 and 25 bps high in 2025. The chart showed 17 of 19 committee members expecting the fed funds rate to finish 2023 above 5%, with 7 of 19 members seeing the benchmark rate above 5.25%. For 2023, the majority of committee members expect the benchmark rate to be above 5%, implying that markets should expect at least three potential hikes in the year. As for rate cuts, the committee repeated its expectations for rate cuts to begin in 2024, as projections showed four potential 25 bps decreases in 2024 followed by four cuts in 2025.

Source: FOMC as of 12/14/22.

After the Fed announcement, the 10-year Treasury ended the day lower by 2 bps to 3.49%; short and long rates were mixed with the 10-year/2-year Treasury spread finished the day at -0.74%.

10-Yr Treasury Yield over the last 12 Months
Source: FRED as of 12/14/22. U.S. Department of the Treasury as of 12/14/22.

In Conclusion

Markets closed in negative territory on the final day of the FOMC meeting. Both the Dow Jones Industrial Average and S&P 500 Index moved lower (-0.42%and -0.61%, respectively) during Chair Powell’s press conference. Treasury yields on the long end moved lower while front-end rates moved up. The 10-year and 2-year Treasury spread increased to -0.74%.

Investors were prepared for the Fed to take a step back, as the committee followed through on Chair Powell’s comments from November about this meeting being the first opportunity to slow the size of rate hikes after making “substantial progress” in the inflation fight. While the PPI for November showed an annual growth rate of 7.4%, down from 8.1% in October, the reading gave a little hope to investors of a potential pause in rate hikes in 2023. But given what has been “long and variable lags” in the effect of this year’s rate hikes and in the rising danger of a recession, the U.S. economy has continued to remain strong, notably in the labor market, as ongoing job creation and unemployment rate stability has kept inflation at elevated levels. In most scenarios, a strong economy would be a positive catalyst for upward momentum in asset prices, the economic resilience has actually been a curse more than a gift, fueling inflation and causing Fed officials to admit that their job is not yet complete and their monetary policy is still nowhere near “sufficiently restrictive.”

While economic conditions have improved, Fed officials have signaled once again that inflation needs to fall further before they even consider halting or much less cutting rates. With revised projections for the fed funds rate and potentially more economic pain to come in 2023, markets will have to see if the Fed’s aggressive rate hikes can gain more traction before the next meeting.

Definitions

One basis point is equal to 0.01%.

Gross Domestic Product (GDP) is the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period.

Personal Consumption Expenditures (PCE) refers to a measure imputed household expenditures defined for a period of time.

The S&P 500 index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.

Disclosures

This publication is provided by Pacific Funds. Pacific Funds refers to Pacific Funds Series Trust. The views of this commentary are as of December 14, 2022, are based on current market conditions, and are subject to change without notice. The views are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector, or index, the offer or sale of any investment, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All materials are compiled from sources believed to be reliable, but accuracy cannot be guaranteed.

Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.

Pacific Life Fund Advisors LLC (PLFA), a wholly owned subsidiary of Pacific Life Insurance Company, is the investment adviser to the Pacific Funds. PLFA also does business under the name Pacific Asset Management and manages certain funds under that name.

Bloomberg Finance L.P. is unaffiliated with Pacific Life Insurance Company, Pacific Funds, their affiliates, their distributors, and representatives.

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