January 30, 2023
Hiking into Recession
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Below is a transcript of this week’s video:
This Wednesday marks the first meeting of the Federal Open Market Committee for 2023. Investors’ expectations, as derived from the fed funds futures market, are currently calling for a quarter point increase to the fed funds rate, with modest potential for a half percent increase. That base case would be another deceleration from December’s half percent and November’s three-quarter percent rate hikes over the prior two meetings, as the Fed seems to be getting closer to its intended target level to fight inflation.
So where does that leave the state of monetary policy? To start, the fed funds rate remains meaningfully above the neutral level, suggesting the state of policy is tight and getting tighter still with another rate hike on deck this week. However, there appear to be disagreements as to the finer points of where monetary policy heads from here. Several Fed officials continue to echo the intentions expressed in the FOMC’s December rate projections, which called for peak fed funds just over 5% and maintaining that rate through year-end. On the other hand, the fed funds futures market suggests investors are betting against such a path. Instead, they are pricing as if the Fed will not reach the 5% threshold, and perhaps even cut rates a few times in the back half of 2023. This discrepancy will have investors on the edge of their seats at Chairman Powell’s postmeeting press conference, parsing his words and listening for any clues of a pivot in intentions.
Putting those finer points aside, it’s helpful to take a step back and see the bigger picture. The result of nearly a year of aggressive rate hikes has led to considerably tight monetary policy. In the past, when the fed funds rate first passed through the neutral level to turn tight, that has often started the clock for an economic recession in the U.S., which tended to show up 1-2 years after that point. Why the lag? It often takes time for monetary to permeate into the economy, often in the form of higher borrowing rates and reduced demand.
A good example of this is the housing market, which is typically one of the more interest-rate-sensitive sectors of the economy and the first to turn over when monetary policy gets tight. For example, the fed funds rate is highly correlated with prevailing the 30-year mortgage rate for new loans. All else equal, that higher rate disincentivizes home buyers at the margin, leading to lower demand. That impact can be felt relatively quickly. However, it takes time for those higher rates to seep into higher borrowing costs for homeowners overall, or the average existing mortgage rate. For example, it also incentivizes those who locked in lower mortgages to stay put in their current homes to avoid taking on a new mortgage at a higher rate. As a result, it’s only a gradual process through which these higher rates impact the budgets of borrowers at the economy-wide level.
As tighter financial conditions continue to seep through into the economy in the form of higher interest cost burdens, investors should monitor the ability of consumers, businesses and the government to service their debts. What determines how quickly those costs may rise? A significant factor is how soon they must return to the debt markets to borrow again. For instance, the federal government’s interest costs as a percentage of its revenues have ticked up higher. With the federal budget operating at a deep deficit, new spending must be financed with new debt and existing debt must be rolled over as it comes due. As a result, higher rates are starting seep through into higher interest cost burdens. Businesses overall tend to operate with existing debt, too, but the average business is a profitable one. Rather than being forced to roll over existing debt, some could choose to retire at least some of that debt with profits to avoid the impact of higher rates. That’s perhaps a big reason why interest cost burdens have remained so low for now. Consumers are a bit of a unique case. Mortgages make up the vast majority of household borrowing, for which they typically have a good degree of optionality for when and how they take on new debt. New prospective homebuyers could avoid higher interest rates by choosing to rent and existing homeowners can avoid them by remaining in their current home. It’s therefore not surprising to see consumer interest costs as a share of disposable income not much changed from prepandemic levels. But all together, even though the Fed is on pace to slow its rate hike cadence, the impact of tight policy should continue to flow through the economy gradually over time.
In summary, expect the Fed to raise rates by a quarter point this Wednesday, with a half percent increase a low probability but not impossible event. There’s a bit of a disagreement on where monetary policy goes from here, with the Fed calling for 5%+ rates and keeping them through year-end, and markets betting they’ll fall short of 5% and cut in late 2023. All these rate hikes have stacked up well above neutral, which in the past has been a precursor to recession a year or two down the line. Finally, it’s a gradual process through which higher rates impact consumers, businesses and the federal government, but those higher borrowing costs should seep through to interest burdens over time.
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