2023 Prologue – The Federal Reserve Gives Tightrope Walking a Try

Between wars, $6/gallon gasoline, and mid-term elections, 2022 had a lion’s share of surprises for everybody.  Inflation, which I nominate as the “boogeyman” of the year, finally seems to be retreating.  The month-over-month readings in the Consumer Price Index have decreased from +1% monthly changes last spring to 0.4% and lower over the last few months. 

It’s encouraging, but the Federal Reserve’s work isn’t done yet.  On an annualized basis, inflation is still over 7%, led by rising food and housing prices.  Policymakers would like it closer to 2%, which would suggest continued restrictive monetary policy and high interest rates through 2023.

Graph of the annualized change in the inflation, as measured by the Consumer Price Index back to 2000
Source: Bureau of Labor Statistics

However, there are signs the economy is starting to weaken in response to elevated interest rates.  This presents the Federal Reserve with a unique balancing act for the next year: taming any remaining inflationary pressures without causing a broader economic slowdown.  This could be challenging for a variety of reasons, but especially due to something called “policy lag.”

The Federal Reserve’s Lagging Problem

Perhaps topping the list of reasons why I don’t want to work at the Federal Reserve is the dreaded “policy lag.”  This refers to how changes in monetary policy can take anywhere from 6 to 12 months to “work their way” into economic data.  In other words, interest rate increases at the beginning of 2022 might only now be starting to be reflected in economic data, while more recent increases may well only be felt during the second half of 2023.

This can lead to a potentially dangerous situation where the Fed falls behind the curve, making life stressful for many.  For example, inflation roared to new highs in early 2021, and the Federal Reserve started taking policy action to control it at the end of that year.  Because of policy lag, it took until late 2022 for inflation to cool off.  In addition to pent-up post-pandemic consumer demand, higher overall cost of living likely contributed to a drop in personal savings rates.  Based on the University of Michigan’s consumer confidence surveys, 2022 was an economically unpleasant year for many.

Graph of the personal savings rate back through 1992.  The savings rate has been falling sharply following the spike higher during the pandemic period.
Source: St. Louis Federal Reserve

The Federal Reserve’s policy challenge now is to know when to switch from tighter to looser monetary policy to mitigate the effects of any pending economic slowdown.  If it waits to loosen until economic data materially weakens, it won’t be able support the economy until the 6–12 month policy lag elapses.  In fact, because of the lag, tighter financial conditions may persist into the early stages of a slowdown, which could further hamper economic growth.  The chart below illustrates the risk of the Fed waiting too long to reverse an overly restrictive monetary policy.

Graph illustrating how the impacts of monetary policy lags actual economic growth and how this can present policy makers with challenges.

The Fed’s solution is to pause interest rate hikes around March of 2023 and wait to see how the economy fares.  I think this is a good middle ground between Wall Street’s caricature of Fed policy, “hike until something breaks,” and loosening too early, which could reignite inflationary pressures.  Even so, soft data, including global business surveys and business sentiment, and some hard data (housing market statistics, job postings, industrial production) are already suggesting waning economic strength, which is going to make the Fed’s job of conquering inflation and averting an economic slowdown difficult.  It’s a metaphorical tightrope for sure.  Our investment strategy position, which has remained largely unchanged since June 2022, is to continue erring on the side of caution by investing relatively conservatively until economic headwinds subside.

If 2023 Includes a Recession:  The Silver Lining

2022 was particularly brutal on pocketbooks, with the cost of goods, gasoline, and services shooting to levels unseen in our lifetimes.  It was similarly tough on portfolios, specifically bond investments.  Stocks, represented by the S&P 500, fell 19.4%in 2022, which was obviously not welcome, but was well within the range of normal returns for a traditionally more aggressive asset class.  Bonds, the traditional “safe haven” investment, fell 13.0%, the worst yearly return in modern history.  Bonds typically perform well when stocks do poorly, offering diversification.  That didn’t happen in 2022, as runaway inflation and higher interest rates threatened the value of regular interest payments.

I firmly believe that period is behind us, and bonds will again diversify a stock portfolio.  This means that, even if the economy enters a recession in 2023, bonds should help blunt the sting of potentially lower stock prices.  I also expect loan rates to begin drifting lower by the end of 2023, making car loans, mortgages, and credit in general cheaper.  As noted in my last commentary, recessions offer opportunities for those prepared to take them.  A dream house, car, vacation can be more affordable during a slowdown, when demand falls and prices/interest rates drop.  The key is to begin preparing for those opportunities during better economic times (now) by saving more and not extending yourself.

Between the economy, markets, and geopolitics, 2023 should be a memorable year.  We’re prepared, with our financial plans and cutting-edge investment strategies, to help ease the downs and seize the opportunities on the ups.

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