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February 22, 2023—After spending all of 2022 flipping the monetary policy switch from accommodative to restrictive, the Federal Reserve (Fed) is now in calibration mode, and the path of inflation will determine where interest rates go from here. Last year’s rate hikes are weighing on economic growth as intended, and inflation is decelerating. The key question is whether inflation will continue to decelerate or if higher rates are needed. Equity markets are off to a very encouraging start just six weeks into the year but will be at risk of another retrenchment if inflation does not slow.

Calibration mode

The Fed has completed the so-called front loading of rate hikes that dominated markets in 2022. The fastest rate-hike cycle in decades, thus far, included four consecutive hikes of 75 basis points, or bps, bookended by hikes in pairs of 25bps and 50bps, raising the federal funds rate by a total of 4.25%. The mantra from the Fed was rates need to be well into “restrictive territory,” meaning above its estimate of the neutral rate of 2.5%, as shown in Figure 1. Moving from near-zero at the start of 2022 all the way to nearly 5% is akin to the Fed taking its foot off the economy’s accelerator and pushing on the brake.

From here, Fed Chair Powell and the rest of the Federal Open Market Committee (FOMC) will calibrate future increases on the evolution of macroeconomic data. Readings on inflation will be paramount, naturally, but indicators that portend future price changes get some consideration. Those include business and consumer expectations for inflation, price pressures on producers, and wages. Such forward-looking indicators are helpful, but Powell was clear during his February 1 press conference and in an interview the following week that the FOMC does not have much confidence in its ability to forecast inflation. The FOMC looks like it will be following through on its expectation to hike by 50bps more, bringing the target range to between 5.00% and 5.25%. Anything past that will hinge on inflation reports.

Figure 1: Federal funds rate (top of target range, %)

The mantra from the Fed was rates need to be well into “restrictive territory,” meaning above its estimate of the neutral rate of 2.5%

Sources: Federal Reserve Board, WTIA. Last data: Jan 2023.

Inflation data improving, but slowly

Price pressures continue to ease, but problem areas remain. In January, overall inflation fell to 6.4% year over year (y/y), the lowest in 14 months (Figure 2). Readings should fall quickly over the next six months as the energy price impacts from Russia’s invasion of Ukraine a year ago roll out of the y/y calculation. Core inflation—which removes food and energy—at 5.6% has been more stubborn and is likely to drift down only slowly in coming months as it does not have favorable base effects from a year ago.

Core goods prices have been on the decline as retailers discount items that had surged during the pandemic and supply chains improve. Home prices, rents, and the prices of consumer services continue to rise uncomfortably. Home prices have taken a hit in the face of high mortgage rates while rents have plateaued nationally and are falling in many markets, which should play through to the deceleration of shelter inflation by mid-year. But labor shortages and wage pressure are keeping consumer services prices from slowing, an issue we expect to see continuing over the course of this year. We discuss this in our 2023 Capital Markets Forecast.

Figure 2: Inflation slowing

CPI inflation (month over month, %)

Price pressures remain

Sources: Bureau of Labor Statistics, WTIA. Historical data through January 2023.

Core narrative

The positive start to the year for equities is encouraging, but we remain cautious. Many of the market swings come from signals one way or the other about inflation, which in turn drive expectations for Fed policy. Encouraging inflation signals in January helped to boost equities but a souring picture in February is boosting rate expectations and large-cap stocks have flatlined. We expect inflation to slow but are cognizant it could break either way. Even slowing inflation may not be at a rate quick enough to calm the nerves of the FOMC.

We place a 55% probability on a mild recession in 2023 and a 40% chance of a soft landing, with the balance allotted to a small chance of a severe recession. Although we expect a continued sharp slowdown in inflation, we expect it to settle in above the Fed’s target over a multi-year period. We maintain a neutral weight on U.S. equities and emerging markets equities with a slight underweight to developed international markets, relative to our long-term benchmarks. We also have a slight overweight to cash, which we look to deploy as our views evolve.


Basis points refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument.

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