The drop off in headline inflation numbers may have led the US Federal Reserve (Fed) to slow down on policy in December, but the longer-term risks to growth are piling up as the bank signals interest rates will be higher for longer.
What Happened?
As expected, at its December meeting the Fed slowed down the pace of hikes to a 50 basis point clip after four 75 basis point increases in a row. However, for those worried the US central bank might push the economy into recession, that was the only relief on offer.
The Fed’s dot plot projection of where rates go from here showed a higher terminal rate of 5-5.25 per cent and its forecasts also now show lower growth for 2023 and higher inflation than previously.
In his press conference Chairman, Jerome Powell, insisted that the Fed needs to see inflation coming down sustainably before restrictive policy can be changed, and he highlighted the potential stickiness of core inflation which lies ahead. Powell also pointed to structural labour shortages in the system which may keep inflation elevated, signalling rates may be higher for longer.
Our Interpretation
The bulk of the bank’s monetary tightening has now already been delivered and as we approach terminal rate the focus will be on how long the Fed intends to stay there. Headline inflation is likely to fall sharply next year on the back of base effects, but core inflation remains the final battleground. Although the latest CPI print was soft, the Fed's insistence that it wants to see a sustained reduction in inflation means the restrictive policy will remain, which in turn raises downside risks to growth.
Our outlook
We remain of the view that a recession in the US is very likely to come through by the middle of 2023. Here, the Fed's insistence on keeping rates meaningfully above neutral raises the risk of further damage to the economy. Indeed, if official rates remain high going into 2024, the risk will grow of a deeper and more lasting balance sheet recession as the refinancing of corporate balance sheets starts rolling into the higher rates.
Asset allocation implications
We remain defensive on equity exposure given the elevated risk of a recession and the relatively mild pricing for such an outcome in stock markets. That said, we remain positive on duration and high quality fixed income (government bonds and investment grade credit) as the Fed tightening drives us past peak inflation and the damage to growth becomes the key focus.
