Has the Fed won the war on inflation?


A smaller interest rate hike may be signaling the Federal Reserve believes victory over inflation is near. We look at the market implications.


February 2, 2023

Thomas Garretson, CFA
Senior Portfolio Strategist
Fixed Income Strategies
Portfolio Advisory Group – U.S.

The latest round of policy meetings by major global central banks essentially played out in line with consensus expectations this week. For the Federal Reserve, that meant another downshift in the pace of rate hikes, with an increase of 25 basis points (bps) bringing U.S. interest rates to a target range of 4.50 percent to 4.75 percent. In the UK, a 50 bps bump took rates to 4.00 percent, and a 50 bps move in Europe brought rates to 2.50 percent.

Though it appears increasingly certain that all three are nearing the end of their respective rate hike cycles, global markets typically take their cues from the Fed, and from that perspective we think the Fed’s rate hike cycle might have just come to an end.

Job one done

At this point, we think it’s clear that the Fed was behind the curve on inflation, playing catch-up over the course of 2022. But with the latest rate hike, that goal has finally been achieved. The U.S. policy rate now exceeds the most recent (December 2022) core inflation reading from the Fed’s preferred barometer, the Personal Consumption Expenditures Index, for the first time since the last rate hike cycle.

The U.S. policy rate is now above inflation, setting the stage for the Fed to pause

Federal funds rate and U.S. core inflation

The line chart shows the upper bound of the Federal Reserve’s target policy rate range and year-over-year core PCE inflation since 2014, and forecasts through December 2023. The upper bound of the target policy range is now at 4.75%, exceeding the latest core inflation reading of 4.4% from December 2022. Both the federal funds rate and core inflation are projected to decline through 2023.

  • Federal funds rate
  • Federal funds rate forecast
  • Core inflation y/y
  • Core inflation y/y forecast

Source – RBC Wealth Management, federal funds rate forecast based on RBC Capital Markets projections, core PCE inflation forecast based on Bloomberg consensus survey for January 2023

We now know that inflation through the fourth quarter of last year was actually lower than the Fed had expected at its December meeting. At that time, policymakers believed rates would have to rise as high as 5.25 percent this year. But at his post-meeting press conference, Fed Chair Jerome Powell noted early signs that “disinflationary pressures” are beginning to take hold; in our view, this could lay the foundation for the Fed to begin lowering its inflation forecasts when policymakers next update their economic projections at the March meeting – and, as a result, its rate hike forecasts as well.

Data dependency

The major changes in the Fed’s latest official policy statement were removing verbiage around the pace of rate hikes and refocusing the outlook on the extent to which rates ultimately need to rise. Though Chair Powell already alluded to this last year, the new statement appears to confirm that the days of jumbo-sized rate hikes are indeed over, and that the Fed is now looking for an appropriate level at which to pause.

We would go so far as to say that the war on inflation is all but over, but note that questions about the true extent of tightness in the U.S. labour market remain unanswered.

And so it is jobs, not inflation (though the two are related) that may ultimately dictate when the Fed does indeed pause. With that in mind, markets won’t have to wait long for confirmation that the Fed will raise rates “a couple more times” – as Powell stated he still believes will be necessary – or if a pause is coming sooner than expected.

The Feb. 3 Nonfarm Payrolls report is expected to show a slowdown in hiring, a modest uptick in the unemployment rate to 3.6 percent, and wage growth slowing to 4.3 percent y/y from 4.6 percent previously. But beyond these incremental numbers, we are also watching for the traditional annual revision report for 2022 that will be released alongside it, which may show that job gains in 2022 were not quite as robust as previously thought after being calculated with more complete and robust data.

Quickly fading inflationary pressures paired with a softening labour market, on top of a recent rise in layoff activity, support our view that the Fed has already done enough and the pause is already here.

Don’t just take our word for it

Markets have spoken. After a year in which Fed policymakers were quick, and successful, in quelling any market doubts about their resolve to raise rates aggressively in the war against inflation, Fed Chair Powell largely stood down from any such notion. We think this shift was likely the primary impetus behind this week’s positive market reaction to the latest round of central bank rate hikes.

Treasury yields, specifically the benchmark 10-year Treasury note, dropped sharply again this week on fading rate hike and inflation fears, extending a decline that began late last year. Since peaking at 4.24 percent on Oct. 24, 2022, the 10-year yield has slipped all the way to below 3.40 percent. As a result, 30-year fixed mortgage rates have also come off the boil; having touched levels beyond seven percent, they are now on the cusp of falling under six percent, according to Freddie Mac data.

As a result, the Bloomberg US Aggregate Bond Index, which comprises investment-grade bonds across a number of sectors, has just posted its best run of the past 30 years. As the average yield on the index has declined from a high of 5.2 percent last year to 4.2 percent this week, the average price of bonds in the index has jumped to US$93 from US$85 as the two move inversely, driving total returns of 8.4 percent over a period barely longer than three months.

Recent months have seen U.S. bonds’ best run of the past 30 years, up over 8 percent

Total return of the Bloomberg US Aggregate Bond Index over rolling 15-week windows since 1993, ranked

The chart shows the total return of the Bloomberg US Aggregate Bond Index over rolling 15-week windows during the past thirty years, ranked from the worst returns to the best. The worst window was from January 2022 through May 2022, with total returns of -8.9%. The best window was from October 2022 through February 1, 2023, with total returns of 8.4%.

Source – RBC Wealth Management, Bloomberg US Bond Aggregate Index; shows rolling 15-week total returns since 1993 ranked from smallest to largest

Not to be outdone, the S&P 500 closed at 4,119 after the Fed’s meeting on Feb. 1 – its highest closing level since August of last year – and is now up over 15 percent from its Oct. 12, 2022 low.

The narrative has changed

While it has been a feel-good week for markets, and there are risks that the labour market could remain strong in the face of aggressive Fed action, we think markets are back in control. The Fed was successful last year in pushing back against markets that at times became too optimistic too early. Now it is markets that are saying the Fed has done enough, as pushback from the Fed wanes.

Markets will undoubtedly have plenty to worry about in 2023, but we have greater confidence now that the Fed and risks around overtightening will at least be one less thing.

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Thomas Garretson, CFA

Senior Portfolio Strategist
Fixed Income Strategies
Portfolio Advisory Group – U.S.

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