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  • Writer's pictureConnie Chan

As Inflation Retreats, Traders See a Dovish Fed in 2023

US inflation has gradually fallen for six consecutive months. After the December CPI release traders have lowered the odds of a 50-basis point rate hike at the next Fed meeting and most now see a 25-basis point rate hike.

US inflation rose at an annualized pace of 6.5% in December and fell 0.1% on a monthly basis. Inflation has gradually come down for six months now even though it is still quite high for comfort.

The Fed front-loaded its rate hikes last year and after starting with a 25-basis point rate hike in March, it soon graduated to 75-basis point rate hikes.

However, in December, the US central bank raised rates by 50 basis points which was in line with expectations. While US inflation fell last year, economic growth also slowed down, which prompted the Fed to slow down the pace of rate hikes.

The next Fed meeting would begin on January 31 and conclude on February 1. According to the CME Fed Watch Tool, traders see a 93.7% probability of a 25-basis point rate hike at the upcoming Fed meeting.

A week ago, only 75.7% of traders expected a 25-basis point rate hike while the remaining believed that the Fed would raise rates by 50 basis points.

As US Inflation Fell Traders Lowered the Odds of a 50 Basis Point Rate Hike

As US inflation fell, traders also lowered the odds of a 50-basis point rate hike. Currently, the Fed fund rate is 4.25-4.50%. The December dot plot calls for another 75-basis point rate hike in 2023.

At the press conference following the December FOMC meeting, Fed chair Jerome Powell said, “We continue to anticipate that ongoing increases will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.”

While he pointed to the “welcome reduction” inflation, he added, “But it will take substantially more evidence to give confidence that inflation is on a sustained downward path.”

High inflation and the resultant rate hikes took a toll on risk assets last year. However, some investment strategies can outperform during high inflation.

The markets misjudged Fed’s resolve to fight inflation and many analysts predicted a Fed pivot in 2022 only. However, Powell made it amply clear that a rate cut is not yet on Fed’s radar. He cautioned against pre-mature rate cuts and said that the Fed might keep rates higher for longer.

Jeremy Siegel Believes the Fed has “Solved” the Inflation Problem

Wharton professor Jeremy Siegel said, “The Fed is, at some time, going to be forced to realize that we’ve really solved the inflation problem.” Previously, he said that the Fed would pause after a 50-basis rate hike in December.

Now, he has said that he’s “not gonna quibble about 25 basis points,” a reference to the expected rate hike at the next Fed meeting.

He added, “Powell’s over-concern about wages, which have not caught up to inflation over the last two-and-a-half years since Covid, … is unfair to the workers, and not something the Fed should be looking at right now.”

Notably, Powell has expressed concern over rising wages and tight labor markets. Many economists criticized Powell for his views on rising wages as average wage growth has lagged behind inflation for quite some time now.

That said, higher wages and high rents make the Fed’s job of targeting inflation somewhat difficult as the combination of the two leads to sticky inflation.

Recession Fears Rise amid Rate Hikes

While central banks globally have raised rates to combat inflation, it is also leading to a slowdown in growth. The World Bank has slashed its 2023 global GDP growth forecast to a mere 1.7% which is way below its previous projection of 3% growth. It also fears a recession this year amid slowing global growth.

It blamed the global monetary policy tightening for the slowing growth. The World Bank said, “Global growth has slowed to the extent that the global economy is perilously close to falling into recession.”

While warning of a possible recession in 2023, the World Bank lowered the growth forecast for several economies. It now expects the US GDP to expand by only 0.5% which is 190 basis points lower than the previous projection of 2.4%.

While recession impacts most sectors of the economy, some of the investments are largely recession-proof.

US stocks along with most other risk assets tumbled in 2022 amid the deteriorating macro environment. Multi-decade high inflation, recession fears, and the fallout of FTX bankruptcy also took a toll on digital assets last year. We have a guide on whether crypto is recession-proof.

Disclaimer: This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.

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