Will Monetary Policy Become Less of a Headwind for Markets in 2023?
Yes. Markets will be less vulnerable to rising rate risk next year, as the aggressive tightening that has weighed on markets for much of 2022 has moderated more recently since inflation has slowed. However, we see a pause in tightening as more likely than a pivot to easing in 2023 because inflation will be slow to further decelerate. Without a pivot to easing, it is difficult to envision monetary policy becoming a major catalyst for a market rebound given the macro environment remains challenging.
Last week, several central banks opted to slow the pace of tightening in their final policy meetings of 2022. Most notably, the Federal Reserve, European Central Bank (ECB), and Bank of England (BOE) each increased their main policy rates by 50 basis points (bps), down from 75 bps at their previous meetings. The Bank of Japan (BOJ) remained an outlier. After being one of few central banks not to tighten policy in 2022, it surprised markets this week by widening the target range of the ten-year Japanese government bond yield to 50 bps (from 25 bps) around zero as part of its yield curve control policy.
Aside from the BOJ’s surprise “tightening,” most central banks are slowing the pace of rate hikes to better calibrate policy as they assess the economic impact of this cycle’s rapid tightening and because inflation has slowed in recent months. In the United States, the consumer price index (CPI) rose 7.1% year-over-year in November, down from a four-decade peak of 9.1% in June, and the core CPI has eased more than expected for two consecutive months. The inflation picture in Europe remains more precarious than in the United States, given the war in Ukraine and the energy crisis, but even in Europe, there are signs inflation may have peaked. The UK CPI rose by 10.7% year-over-year in November, down from a 41-year high of 11.1% in October.
The downshift in the pace of rate increases was widely expected given the recent softening in inflation. Odds of a 50-bp hike by the Fed in December increased from as low as 22% in mid-October to above 80% by last week’s meeting. Over this period, investor sentiment had improved, with both equities and bonds rallying and the dollar weakening. Sentiment has soured since last week’s policy meetings though—investors may have gotten ahead of themselves in equating the recent softening in inflation with a rapid decline, and slower tightening with lower peak rates and potential easing next year.
While recent data show a welcome reduction in inflation, it is clear most officials at the Fed, ECB, and BOE still believe there is a long way to go to return inflation to their price targets. The Fed revised up its median inflation forecast for 2023 and most officials projected the Fed will need to raise the Fed funds rate from its current target range of 4.25%–4.5% to above 5%, up from its median projection of 4.6% in September. Following the Fed’s lead, the ECB and BOE also raised their inflation projections for 2023 and signaled additional rate increases were necessary to sustainably bring down inflation.
We largely agree. Inflation remains well above most central banks’ inflation targets, and we anticipate it will be slow to decelerate next year. Inflation has moderated in some segments of the economy as supply bottlenecks have improved, but other key sources of inflation remain strong. US shelter prices rose 0.6% month-over-month in November and a broader measure of “sticky inflation” sources continued to accelerate. Strong wage growth, which is supported by persistent labor market strength, could offset any decline in other sources of inflation next year unless there is a significant softening in the economy.
In addition, even if we assume the Fed increases rates by another 75 bps in 2023, as the latest projections suggest, then it will have only raised rates by a total of 500 bps this cycle, which is only an average degree of tightening based on previous tightening cycles. And it has typically taken significantly more tightening than usual to bring down inflation when it is elevated. Further, history suggests it would be unusual for the Fed to be able to cut rates by the end of next year without a rapid decline in inflation, considering it continued raising rates until inflation had fallen below the funds rate in every tightening cycle but one, and it hasn’t started cutting rates on average until five months after its last rate hike.
Therefore, we see a pause in tightening as more likely than a pivot to easing in 2023, as inflation will be slow to further decelerate, causing the Fed, and most other central banks, to hold rates higher for longer.