Fed can move at slower pace as inflation eases

The slower December inflation print from the US, along with near-term indicators of a widening slowdown in the US economy, will allow the Federal Reserve to slow down its pace of monetary tightening in 2023. Headline CPI in the US eased to 6.5% y/y in December, its slowest pace of gains since October 2021. Crucially, core CPI—which strips out fuel and food prices—also reflected a slowdown. With the Fed’s focus squarely on prices, the slowdown should convince policymakers that the 425bps of hikes taken last year are starting to have an impact on consumer demand for goods and services while exogenous effects, like lower housing costs and health care premiums, will also help to bring prices lower in 2023.

The FOMC meets in a few weeks’ time with the first decision of the year set to be announced on February 1. The latest CPI print affirms our expectation of a 25bps hike at the early February meeting, which would take the Fed Funds rate to 4.75%. Currently, markets are also expecting a 25bps hike from the Fed. We anticipate that the February decision will come with some still hawkish language, roughly boiling down to the Fed preferring to put inflation in the grave rather than chance it re-emerging by easing policy too early. The minutes of the December FOMC meeting cautioned against “unwarranted easing of financial conditions” and a further pullback in UST yields—the 10yr yield has already dropped more than 30bps since the start of the year—may prompt more chiding from Fed officials that markets are getting ahead of themselves.

The Fed likely has different thresholds for slowing the pace of tightening, holding rates at an elevated level and finally moving to an accommodative stance (either via cuts or reintroducing QE). It does seem evident that the first of those thresholds has been crossed: the Fed has moved from 75bps hike to 50bps in December and is lining up for 25bps in February. We expect that at least one more 25bps hike will be on the cards in H1 as while inflation is slowing, it is still considerably above target.

What happens for the rest of 2023 is more uncertain. Markets are pricing in rates moving lower from July, likely on the back of the Fed blinking at what may be rising unemployment and more evidence of a recession in the economy. At this time, we do expect that the Fed will need to shift to an accommodative by the end of the year, but we will wait until we get a clearer data picture for how Q1 2023 shapes up before we endorse that view with more conviction.