Another Dip in Inflation, But Fed Keeps Talking Tough

In a rare overlap of inflation data release and the Fed’s monthly meeting, markets participants bore the burden of quickly digesting the implications of a 7.1% Nov ‘22 inflation reading followed by the Fed’s much anticipated rate decision only a day later. Consistent with projections, the Fed slowed down it’s pace of rate increases on Dec 14th, raising interest rates by only 50 bps to hit a new range of 4.25% - 4.50%. The previous four meetings saw increases of 75 bps each, a torrent pace of increases considering where rates sat for much of the prior decade. The Fed’s decision to slow it’s pace reflects the easing of inflation in recent months. Inflation peaked at 9.1% in July ‘22 and has gradually fallen since, but only by very small increments of around 0.5% or less. For a broader perspective on inflation, we’ve now spent the last 12 months above 7% and 18 months above 5%. Persistent, I dare say.

Powell indicated “we think that the appropriate things to do now is to move to a slower pace”, but still stay on track with rate hikes consistent with hitting a peak level of 5 - 5.5% in 2023 and an eventual easing of rates in 2024. The Fed appears well aware of the fact that their job is not over. It’s been commonly said that inflation can’t be controlled until the Fed Funds Rate exceeds CPI. The gap is shrinking, but still far from parity.

With Dec’s rate hike now behind us, a lot of attention will be drawn to forthcoming economic data releases. These numbers should inform the Fed’s ability to continue raising rates in 2023, or at the minimum, keep them at current levels. A look at the 10-year treasury yield, which has steadily drawn back from it’s Oct 19th peak of 4.23% to 3.48% today, reveals that investors expect inflation to decline on the heels of a coming recession. This is further reinforced by a current sharp yield curve inversion. The 3-month treasury yield at 4.26% holds a negative 78 bps gap to the 10-year treasury yield. There’s a similar spread to the 2-year treasury yield currently sitting at 4.22%. When the short and long yields invert the way they are now, it’s a near perfect historical indication of a coming recession in the next 12 - 18 months. It’s important to remember we’re now into our second month of yield curve inversion making Q1 2024 a very important economic data period for us all to keep an eye as we soon cross into a New Year and another period of tough decisions for the Fed.