Federal Reserve Remains Hawkish on Interest Rates Amid Fears of a Looming Recession
The Fed is expected to continue to tighten monetary policy in 2023— albeit in smaller increments—and maintain higher policy rates for an extended time.
Commentary
Fed remains cautious on inflation and against “prematurely” pivoting
from higher rates
A series of rate hikes by the Federal Reserve in 2022 has left the benchmark federal
funds rate in a target range of 4.25%–4.50%.
1
In December, the central bank
raised its policy rate by 50 basis points, moderating the pace of increases after
four consecutive 75 basis-point moves. At their first meeting in 2023, policymakers
lifted the policy rate by 25 basis points to a range between 4.50% to 4.75%, the
highest level since 2007. Still, the Fed has signaled plans to continue to tighten
monetary policy and maintain a higher level of interest rates for longer than current
market pricing suggests. Fed Chair Jerome Powell has said that long-term inflation
expectations need to be “well-anchored,” and that the “historical record cautions
strongly against prematurely loosening policy.”
The Federal Open Market Committee (FOMC) continues to reiterate its commitment
to achieve maximum employment and bring inflation back to its 2% target.
2
In
recent weeks, some members of the FOMC have discussed a further moderation
in the pace of rate hikes, while suggesting that rates will need to remain sufficiently
restrictive for some time to ensure that inflation returns to 2% on a sustained basis.
Money Markets
Federal Reserve remains hawkish on interest rates amid
fears of a looming recession
KEY TAKEAWAYS
•
To combat unacceptably high levels of inflation, the Federal Reserve is expected
to continue to tighten monetary policy in 2023—albeit in smaller increments—and
maintain higher policy rates for an extended time.
•
The Fed raised the federal funds rate by 425 basis points in 2022, taking the target
range to 4.25%–4.50%. In February, the central bank lifted the benchmark rate by
another quarter percentage point.
•
Inflation pressures are beginning to show signs of easing, while U.S. growth is
likely to decline in 2023.
•
A resolution to the debt ceiling is expected to meaningfully increase the supply of
Treasury bills.
•
Money market flows trended higher through the end of 2022, buoyed by further
interest rate hikes and market volatility.
Kerry Pope, CFA
Institutional Portfolio Manager
Money Markets
|
2
Source: Federal Reserve and Bloomberg Finance L.P., as of Dec. 31, 2022. PCE inflation was not available for December 2022.
EXHIBIT 1: The consumer price index (CPI) and the personal consumption expenditures (PCE) price index
remain higher than the Fed’s 2% target inflation rate.
How inflation and the labor market react to Fed policy changes already in place will help determine
the trajectory of rates going forward. U.S. inflation continued to ease into the end of 2022. While
the consumer price index (CPI) rose 6.5% in December compared with a year earlier, it marked the
sixth straight monthly deceleration from a peak of 9.1% in June.
3
CPI in December fell 0.1% from
the prior month, the first decline in two-and-a-half years. Core CPI, which excludes volatile food
and energy components, rose 0.3% from the prior month and 5.7% from a year ago. In addition,
the Fed’s preferred inflation measure—the personal consumption expenditures (PCE) price index,
excluding food and energy—rose 0.2% in November from a month earlier and 4.7% from a year
earlier, easing from a gain of 5% in October
4
(Exhibit 1). Taken together, the readings point to price
increases moderating in key goods and services. Still, resilient consumer demand—particularly
for services—paired with a strong labor market, will likely keep inflation above target for an
extended period.
Global economies face headwinds and U.S. GDP growth set to slow
The World Bank cut its global growth forecast, warning that new adverse shocks could tip the global
economy into a recession. Global gross domestic product (GDP) is expected to increase 1.7% in
2023 from 3% forecast in June, the Washington-based lender said. The bank, which also cut its
growth estimates for 2024, said elevated inflation, higher interest rates, reduced investment, and
disruptions caused by Russia’s invasion of Ukraine are to blame for the sharp downturn. Meanwhile
in the U.S., the Fed expects growth to be much weaker in 2023 than previously forecast. Real
GDP growth expectations were 0.5% in December, down from 1.2% in the projections released
in September. The economy is expected to grow 1.6% in 2024 and 1.8% in 2025, according to the
Fed’s summary of economic projections in December (Exhibit 2).
CPI
PCE Inflation
0%
2%
4%
6%
8%
10%
Jan ‘22
Feb ‘22
Mar ‘22
Apr ‘22
May ‘22
Jun ‘22
Jul ‘22
Aug ‘22
Sep ‘22
Oct ‘22
Nov ‘22
Dec ‘22
Money Markets
|
3
EXHIBIT 2: The U.S. economy is forecast to slow as interest rates trend higher.
GDP % Change
Amid the gloomy outlook, third-quarter GDP growth was higher than previously estimated,
reflecting upward revisions to consumer spending and business investment. Real GDP increased
at an annual rate of 3.2% rate during the period, from a previously reported 2.9%, according
to the Commerce Department in December. Personal consumption rose 2.3% from an earlier
estimate of 1.7%. A strong labor market and wage growth have underpinned household spending,
but it remains uncertain this momentum will continue in 2023 amid higher rates. In addition,
deteriorating sentiment among small-business owners, along with contractions in the Institute for
Supply Management’s gauges of services and manufacturing, signals a material shift in economic
conditions. The fear in the market is that the Fed’s aggressive tightening will ultimately result in a
rise in the unemployment rate and push the economy into a recession.
Source: Federal Reserve and Bloomberg Finance L.P., as of Dec. 31, 2022.
Job growth remained robust, wage gains cooled, and the unemployment rate ticked lower to 3.5%
in December. Employers added 223,000 jobs in December on a seasonally adjusted basis, the Labor
Department said. Wage growth (average hourly earnings) eased to 4.6% from a year ago. A sustained
deceleration in wage growth could offer some comfort to central bank officials that a key driver of
the inflation is losing steam. Fed officials regard wage pressures as a key hurdle to achieving their 2%
inflation goal. The data underscores both the enduring strength of the job market and how a persistent
imbalance between the supply and demand for labor is keeping upward pressure on inflation. That said,
the uptick in the labor force participation rates and the slowdown in wage growth suggest some of the
tightness in the labor market is starting to unwind. The participation rate—the share of the population
that is working or looking for work—ticked up to 62.3%, and the rate for workers aged 25–54 rose.
Quarterly GDP
Federal Reserve's Projections
0%
2%
4%
6%
8%
10%
12%
14%
3/31/21
6/30/21
9/30/21
12/31/21
3/31/22
6/30/22
9/30/22
12/31/22
12/31/23
12/31/24
12/31/25
Money Markets
|
4
Against this backdrop, we expect the Fed to raise interest rates further before pausing to assess
how the most aggressive tightening cycle in decades is impacting the economy. The December
jobs report offered a best case scenario for the Fed—Americans keep their jobs as inflationary
pressures of earnings ease—giving policymakers room to slow the pace of interest rate hikes.
There has been renewed market discussion in recent weeks on the size of the Fed’s rate moves
over the near term. Recent comments from Fed officials seem to converge toward 25 basis-point
increments instead of 50 basis-point hikes. Federal Reserve Bank of Philadelphia President Patrick
Harker, who will be a voting member of the FOMC, indicated a preference for 25 basis-point
hikes going forward as well. In their December summary of economic projections, Fed officials on
average expect to raise their policy rate as high as 5.1% by the end of 2023, before lowering the rate
to 4.1% by the end of 2024
4
(Exhibit 3).
EXHIBIT 3: The Fed’s latest projections suggest the fed funds rate will end this year at 5.1%, while the
market is pricing in rate cuts in the second half of 2023.
Fed Funds Futures vs. Fed Funds Rate
Source: Federal Reserve and Bloomberg Finance L.P., as of Feb. 2, 2023.
0%
1%
2%
3%
4%
5%
6%
Actual Fund Rate
Fed Fund Ceiling
Fed Funds Futures (2/1/23)
Fed Funds Futures (12/31/22)
FOMC Dots Median (12/14/22)
FOMC Dots Median (9/21/22)
Dec ‘19
Dec ‘20
Dec ‘21
Dec ‘22
Dec ‘23
Dec ‘24
Dec ‘25
Dec ‘26
Money Markets
|
5
Source: Haver Analytics and Fidelity Investments, as of Jan. 25, 2023.
A resolution to the debt ceiling showdown could boost Treasury bill issuance
The debt ceiling is the legal limit on the total amount of federal debt the government can accrue.
The limit applies to almost all federal debt, including the roughly $24.3 trillion of debt held by the
public and the roughly $6.9 trillion the government owes itself because of borrowing from various
government accounts, such as the Social Security and Medicare trust funds.
The federal debt ceiling was last raised in December 2021 by $2.5 trillion to $31.381 trillion. The
U.S. reached this borrowing cap, which was expected to last until July 2023, on January 19. As a
result, the Treasury Department must manage debt issuance and use its general account balances
to remain under the ceiling. The Treasury has started using accounting tools at their disposal, called
“extraordinary measures,” to avoid a default and to rebuild its cash balance to a more comfortable
level. This enables the Treasury to temporarily increase bill supply to help fund tax refunds ahead
of the large tax receipts expected in April. Once these measures are exhausted to fund the
U.S. government, a new congressional agreement will be needed to either raise or suspend the
debt ceiling.
EXHIBIT 4: The U.S. has reached the technical debt limit, prompting the Treasury Department to use
“extraordinary” measures.
29
29.5
30
30.5
31
31.5
Jan ‘22
Mar ‘22
May ‘22
Jul ‘22
Sep ‘22
Nov ‘22
Jan ‘23
0
500
1,000
1,50 0
2,000
Headroom Under Debt Limit ($bn rhs)
Debt Limit ($tn)
Debt Subject to Limit ($tn)
$Trillions
Money Markets
|
6
The question remains when Congress will raise the debt ceiling because of ongoing political
divisions among lawmakers. Once the debt ceiling is lifted, an estimated $1 trillion of bill issuance
will shift the supply imbalance and may create an opportunity for money market investors to buy
bills at more attractive levels. The rising supply may coincide with money market fund managers’
willingness to extend portfolio maturities beyond their current record-low weighted average
maturities (WAMs) (Exhibit 5).
EXHIBIT 5: Weighted average maturities for taxable money market funds.
Source: iMoneyNet, as of Dec. 31, 2022.
Money market funds continued to attract inflows
Money market flows trended higher through the end of 2022 as investors shifted from risk assets,
such as equities and bonds, amid rising market volatility and interest rates. Much of the increase
was driven by retail investors’ preference for prime money market funds (Exhibit 6). Total assets in
prime money market funds have steadily increased since mid-2022 as retail investors have found
these yields more attractive as the Fed continues with its hiking cycle. Still, this trend in flows
into prime money market funds could slow or reverse as market participants reallocate to riskier
investments once the tightening cycle passes. Meanwhile, total assets in government money
market mutual funds reached about $4.0 trillion as of December 31.
5
10
15
20
25
30
35
40
Days
Government
Prime
Dec ‘21
Jan ‘22
Feb ‘22
Mar ‘22
Apr ‘22
May ‘22
Jun ‘22
Aug ‘22
Jul ‘22
Sep ‘22
Oct ‘22
Nov ‘22
Dec ‘22
Money Markets
|
7
EXHIBIT 6: Retail investors have driven flows into prime money market funds.
Government vs. Prime Assets under Management
Source: iMoneyNet, as of Dec. 31, 2022.
Prime money market funds took advantage of the additional supply at attractive spreads as
banks extended their liabilities over year-end. As a result, prime money market funds extend their
weighted average maturities in December, while government funds continued to shorten their
portfolios. Overall, government and prime funds’ WAMs registered 8.9 days (-3.3 days month-on-
month) and 14.9 days (+2.5 days month-on-month) at year-end, respectively. Government money
market funds reduced their exposure to Treasury bills and repos in December, investing $220 billion
more in the Fed’s overnight reverse repurchase agreement facility (RRP) from the previous month.
Meanwhile, prime money market funds invested approximately $100 billion more in the RRP in
December from November, shifting money out of bank time deposits, Treasuries, and agency debt.
As a result, the RRP hit a record of $2.55 trillion at the end of 2022. Money market funds made up
about 91% of the total size placed with the central bank.
Government
Prime
0.0
0 .1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
3.3
3.4
3.5
3.6
3.7
3.8
3.9
4.0
4 .1
4.2
4.3
$Trillion
$Trillion
Jan ‘22
Feb ‘22
Mar ‘22
Apr ‘22
May ‘22
Jun ‘22
Aug ‘22
Jul ‘22
Sep ‘22
Oct ‘22
Nov ‘22
Dec ‘22
1
Federal Reserve, Dec. 31, 2022. https://www.federalreserve.gov/monetarypolicy/openmarket.htm
2
Federal Reserve Board, Dec. 14, 2022.
https://www.federalreserve.gov/newsevents/pressreleases/monetary20221214a.htm
3
Bureau of Labor Statistics, Jan. 12, 2023. https://www.bls.gov/news.release/cpi.nr0.htm
4
Federal Reserve Board, Dec. 14, 2022.
https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20221214.pdf
All information as of Jan. 30, 2023, unless otherwise noted.
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Author
Kerry Pope, CFA
Institutional Portfolio Manager
Kerry Pope is an institutional portfolio manager
in the Fixed Income division at Fidelity
Investments. In this role, he is responsible for
communicating portfolio strategy and positioning,
designing customized liquidity management
solutions for institutional clients, and providing
portfolio reviews.
Fidelity Thought Leadership Vice President
Shanthy Nambiar provided editorial direction for
this article.
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