Hard to believe 2022 is already coming to an end! It has been an interesting year to say the least. Inflation proved to not be transitory, Russia and Ukraine went to war, the Fed executed the most aggressive start to a tightening cycle in decades, US equities plummeted 18%+ on the year… We are in a period of radical uncertainty. As PIMCO describes it, “uncertainty [that] can’t be qualified by statistical distributions or probability-weighted average outcomes, but rather is unmeasurable and represents unknowable unknowns…we agreed that the possible outcomes [for growth and inflation] was particularly wide.”
We are going to touch on the improved inflation numbers and the FOMC meeting from this month before jumping into a quick recap on the year.
Moving in the right direction?
CPI cooled significantly in November, coming in at 7.1% year-over-year and only 0.1% for the month. This marks the 5th consecutive month CPI (YoY) has slowed, fueling hopes that inflation peaked at 9.1% in June and will continue to move towards the Fed’s 2.0% target, enabling the Fed to slow the pace of hikes.
And while overall inflation is moving in the right direction, a few components remain stubbornly high–mainly food and shelter. For November, the food and beverage index was up 0.5%, and the index for shelter was up 0.6%, which offset the 1.6% decrease in the energy index.
FOMC meeting.
The Fed hiked its benchmark rate by 50bps at its December meeting to its highest level in 15 years. Though this marked a slowdown from the 75bp hikes implemented in the previous four meetings, Chairman Powell was quick to squash any sentiment that the Fed has accomplished its goal to bring inflation back to the 2% target. “There’s an expectation really that the services inflation will not move down so quickly, so we’ll have to stay at it,” Powell said at his press conference following the December meeting, adding, “We may have to raise rates higher to get where we want to go.”
So, the Fed is admitting the economic environment will likely continue to deteriorate. GDP growth is slowing, unemployment is increasing, and inflation remains well above its 2.0% target.
And while the Fed never projects a recession, at least one member anticipated GDP contraction in 2023 based on the ranges.
The projections also point to a potential break of the Sahm Rule, which the Fed defines as, “(The) Sahm Recession Indicator signals the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to its low during the previous 12 months.”
Given the Fed is projecting the unemployment rate to increase from 3.7% for EOY 2022 to 4.6% EOY 2023, it is likely that the 3-month MA for the unemployment rate will be 0.5% higher than the 12-month low.
YEAR-END REVIEW
It’s always nice to take a moment and review where we were at the start of the year, where markets thought we were heading, and what actually happened.
Where we were:
At the end of 2021, inflation was at 6.0%. The Fed finally stopped using the word “transitory” to describe the uptick in inflation but continued to believe most of the inflation pressure was a result of “supply and demand imbalances related to the pandemic and the re-opening of the economy.” (Obviously, it had nothing to do with years of massive monetary and fiscal accommodation.)
What was projected:
The Fed forecasted inflation to decrease to 2.6% by the end of 2022.
What actually happened:
Inflation is around 5.6% to end 2022, so the Fed was about 3.0% off from its forecast.
Where we were:
At the end of 2021, the unemployment rate was at 4.2%.
What was projected:
The Fed forecasted unemployment to increase slightly to 4.3% by the end of 2022 as the committee slowly began tightening financial conditions to ensure inflation remained in check.
What actually happened:
The unemployment rate dropped to about 3.7% by the end of 2022. (Attributable to the shortage of available workers and likely due to demographic shifts as Baby Boomers reach retirement age and exit the labor force.)
Where we were:
At the end of 2021, GDP was at 5.7%
What was actually projected:
The Fed forecasted GDP to cool to 4.0% by the end of 2022. As the economy re-opened, the strong GDP in 2021 was largely driven by consumer spending. Just a little context, we were coming off a 2.8% contraction in GDP for 2020, so a hot GDP print during the recov- ery wasn’t surprising. But the Fed knew that the growth rate was not sustainable and forecasted GDP to gradually move down to the 1.8% long-term expectation.
What actually happened:
We won’t have the first estimate of GDP for 2022 until the end of January, but it is safe to say it will not be
close to the Fed’s 4.0% estimate. The central bank is now forecasting only 0.5% growth this year.
Where we were:
At the end of 2021, fed funds was at 0.1%.
What was projected:
In December 2021, the Fed forecasted the policy rate to end 2022 at 0.9%, implying three 25bp rate hikes over the following 12 months. Remember, the Fed believed inflation was largely attributable to COVID related issues that would continue to improve as the economy re-opened. Combined with a strong labor market, the committee would be able to gradually increase fed funds to the desired 2.5% level.
What actually happened:
Fed funds is around 4.4% to end 2022, so the Fed was about 3.5% off on its forecast.
Wrapping this up with a bow.
We often talk to clients about the effects volatility (aka ‘uncertainty’) has on option pricing (i.e., caps, swaptions, etc.). When traders are not confident in the future path for rates, they charge a premium to trades as a cushion in case their predictions are incorrect. And when the committee in charge of setting the policy rate is 3.5% off in its forecast over a 12-month period, it does not drive confidence in an individual trader’s outlook.
Can you imagine the Fed saying they believe fed funds will end 2023 at 5.1%, plus or minus 3.5%?
But the biggest takeaway is that the Fed underestimated all of the factors driving inflation
and believed most were attributable to COVID, so they were well behind the curve by the start of 2022. The Fed ignored the effects of years of ultra-loose monetary policy/free money on an economy and the fundamental shift to more open jobs than available workers in the labor force.
So what does this mean for next year?
o the Fed’s credit, they may have been behind the 8-ball coming into 2022, but acted quickly and decisively to tighten conditions at a historic pace in 2022. It appears they got the message and responded appropriately.
The central bank understands it takes time for rate hikes to filter thru the economy, so it is time to slow the pace of hikes and ultimately take a pause. Our baseline is for 2 more 25bp hikes in the first half of next year, followed by a brief pause at a peak rate of roughly 4.90% before implementing the first cut of the cycle in the second half of next year. This is contingent on inflation continuing to slow, where we need shelter cost and wage growth to cool in order to return to a 2.0% inflation range.
Have questions about your next cap or anything else in this update? Give us a call at 980.208.1600 or email info@bascomadvisors.com.
