As we head into 2023, Federal Reserve interest rate policy will remain front and center. Uncertainty surrounding the Fed’s terminal rate and the associated volatility has been a headwind for both fixed income and equity markets. Might we get greater clarity on this as we near the end of 2022?

We see three potential paths for Chair Powell and Company. The first we’ll call "Hike and Pause" – a hike at the December meeting and possibly early next year, then a pause for an extended period of time. The second option is "Hike and Pivot" where the Fed hikes several more times and quickly pivots to cuts early next year as the economy slows aggressively. And last, "Hike, Pause and Hike", also known as the mid-cycle adjustment, where the data remains stubborn, requiring additional hikes later in the year.

Hike? Pause? Pivot?
Hike and Pivot seems the least likely outcome. The Fed has been telegraphing for some time that the idea of rate cuts being imminent is misguided and has been aggressively nudging the markets away from this view. Hike and Pause appears to be the scenario the markets expect, which relies on the Fed stepping back to assess incoming data. Recall that the Fed has three levers to pull when deploying rate hikes: the pace, the size, and the duration.

The Fed pulled the first two levers during its "hurry up to catch up" phase, but more recent comments from officials are noting "two-sided risks" and "lagged effects" from tightening already in the pipeline. This is code for slowing the pace and size of hikes to allow the data to adjust to the effects of previous hikes. The Fed has also hinted that they expect to pull that third lever – duration – for much of 2023. Expect rates to remain in restrictive territory for some time. As the economy slows and rates remain fixed, this implicitly acts as de-facto incremental tightening.

Hike, Pause, Hike…
This brings us to the third outcome – Hike, Pause and Hike – a potential path that many are not contemplating. It’s simply an extension of Hike and Pause, so we’ll build from that. The crux of the issue is cyclical versus structural inflation. Think of cyclical inflation as pandemic- and goods-related. We are already seeing signs of this softening as supply chain issues ease, import prices drop, and retailers report bloated inventories.

The more challenging side is structural – think service and labor-related issues. While we are seeing some early tentative signs of softening, labor markets thus far have remained resilient. The risk? There may be some underlying inflation dynamics that are not fully appreciated post-Covid. Employers may be loath to let employees go after spending months trying to fill vacancies and bring new hires up to speed. And maybe the economy is less interest rate sensitive than we think. All demonstrating that service-related inflation proves stickier than expected.

Risk management is about seeing all the potential outcomes. Hike, Pause and Hike is one outcome that may not be getting enough consideration.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Natixis Investment Managers, or any of its affiliates. The views and opinions expressed are as of December 2022 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.

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