Consumers and businesses holding off taking on more debt until interest rates stop rising may be waiting at least through early 2023 before they see a change in Fed policy, experts say.
Interest rates have been rising since March, when the Federal Open Market Committee (FOMC) started hiking the Federal Funds rate. That's the rate that banks charge each other to lend money, so interest rates paid by consumers and businesses on debt tend to rise along with it. Most recently, on Nov. 2, the FOMC announced that the Federal Funds rate would rise by another 75 basis points (three-quarters of a percentage point) to a target of 3.75% to 4%.
And more increases are widely believed to be on tap.
“Coming into the November FOMC meeting, both the bond and equity markets were prepared for another 75 basis points rate hike, and a step down in the pace of rate hikes going forward towards a terminal rate of 4.5% to 4.75% by March 2023,” said BOK Financial® Chief Investment Officer Brian Henderson.
“But the markets weren’t prepared for Fed Chairman Powell’s comments during the press conference that, while the pace of rate hikes will slow given the lagged and cumulative effects of the rate hikes to date, the ultimate peak in rates is likely to be higher than what the Fed forecasted back in September. The markets are now pricing in a Federal Funds rate above 5% in early 2023,” he explained.
Inflation likely both better and worse than data shows
Already, the Fed's rate hikes have far outpaced expert predictions. Including the most recent increase, the FOMC has raised the Federal Funds rate by 3.75% since the start of the year.
"We came into this year thinking there would be two, maybe three, Fed rate hikes of 25 basis points each," said Steve Wyett, BOK Financial chief investment strategist. "The bottom line is the Fed has raised rates significantly faster and further than we were anticipating because inflation accelerated faster and further than we thought it would."
Headline inflation was up 8.2% year-over-year and 0.4% month-over-month in September, as measured by the Consumer Price Index (CPI). That's down from the end of June, when inflation peaked at 9.1%—the largest 12-month increase in 40 years—but is still "way too high," Henderson said.
CPI inflation data is released with a month lag time, so actual inflation may differ from what the most recent data shows, experts noted.
"It's both better and worse depending on the part of the inflation picture that you're looking at," Wyett said. For instance, prices of some commodities such as lumber, steel and copper are dropping. Even the initial price surge in agricultural commodities such as wheat, corn and cotton has "backed off a bit," he added.
"We're not talking about prices going back to where they were before Russia invaded Ukraine. It would take some disinflation for that to happen, but we are reaching that point where the ascent of prices has started to slow," Wyett explained.
Meanwhile, although the price of gasoline and goods such as used cars are falling, wages and most rents remain high, which means there is still a long way to go before inflation reaches the Fed's target of 2%, Henderson said. High wages bring up the costs of services (such as dining in a restaurant or staying in a hotel), which makes up roughly 60% of the U.S. economy.
Inflation will determine if more surprises are ahead
Just as inflation has necessitated faster and larger rate increases as 2022 has progressed, inflation likely will decide what's ahead from the Fed in 2023—and for markets.
On one hand, if the Fed emphasizes that they’re going to slow the pace of rate increases, that would be an unwelcome surprise for the bond market, especially regarding longer-term bonds, because inflation is still so high and the longer end of the market is highly sensitive to inflation, Henderson said. On the other hand, a more aggressive than expected response from the Fed would also surprise the markets.
And even if rates do stabilize, the question still remains of how long they will need to stay that way before the Fed can start lowering rates, Wyett said. “It may be that the Fed needs to keep rates stable for a little bit longer period of time, so there may yet be some volatility in some of the markets. But if we can get inflation to start to decline and we can start going the right direction, then that could be supportive of the capital markets as we move through 2023.”
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