Posted by Jeffrey J. Roach, PhD, Chief Economist
Wednesday, December 13, 2023
Key Takeaways:
- Since inflation is going in the right direction and the labor market is getting more into balance, the Federal Reserve (Fed) is likely done raising rates. We should expect the committee to prepare investors for a slight pivot in policy.
- The markets expect the Fed’s next action will likely be a cut in rates by mid next year but much of that is predicated on the economy weakening enough to warrant a cut.
- Both equity and bond markets have latched onto the notion that the Fed is done raising rates which has been a catalyst for the recent rally.
- The updated Summary of Economic Projections (SEP) will likely push back on the market’s expectations that the Fed will cut rates by over a full percentage point. But the
SEP is a poor predictor of future rates.
Favorable Inflation Trajectory
The November annual rate of inflation dipped to 3.1% from 3.2% last month as energy prices continued to plummet. Despite the month-over-month rise in November prices, the Fed is still expected to hold rates unchanged at the final meeting of 2023. Rising shelter costs, medical care, and car insurance prices were the main drivers in November’s Consumer Price Index (CPI), but the decline in apparel was revealing. Apparel declined by 1.3%, the largest monthly decrease since the onset of the pandemic and could illustrate the growing price-consciousness of the consumer.
The decline in aggregate goods prices could be in response to the bargain hunting at the start of the holiday sales season.
Further, the soft reading from the latest Producer Price Index (PPI) shows the pipeline of inflation is loosening, giving the Fed some leeway with future policy. For now, investors will have to come to grips with the diverging glide paths between goods prices and services prices. As shown in the chart, the annual growth rates between services and goods are getting closer into balance but services disinflation has more room to run.
Too Early to Declare Victory
The Fed will by no means declare victory since the annual core inflation rate (excluding food and energy) in November was 4.0%, double the long-run target rate set by the Fed. However, the trajectory is encouraging.
As noted in the chart above, the annual rate of headline inflation is 3.1% and will likely decline further from here. Despite inflation running above the Fed’s target, the Fed will likely hold rates steady at the next few meetings as policy makers—and investors too, for that matter—remain concerned about the lagged effects of monetary policy. Given the speed of the past rate hikes, many argue the economy and markets have not yet felt the full impact of the policy tightening.
From an investment standpoint, markets will need to digest the updated Summary of Economic Projections (SEP) which will likely show expectations the Fed will not cut rates as aggressively as markets are anticipating in 2024.
Overall, the Strategic and Tactical Asset Allocation Committee (STAAC) recommends a neutral tactical allocation to equities, with a modest overweight to fixed income funded from cash. The risk-reward trade-off between stocks and bonds looks relatively balanced to us, with core bonds providing a yield advantage over cash. With the Fed likely done hiking rates and yields at attractive levels, bond returns have become increasingly competitive with equities.
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