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With latest interest rate hike, 2023 economic forecast gets cloudier

Fed officials project rising unemployment, slowing growth in 2023.

Fed Chair Jerome Powell testifying
Fed Chair Jerome Powell. (en.m.wikipedia.org)

As the Federal Reserve seeks to bring down inflation, it is walking an economic tightrope. It is raising interest rates to cool demand so that prices will fall, but it doesn’t want to slow activity so much that it causes a recession.

Interpreting this complex picture requires watching the Fed’s actions on a number of levels. With Thursday’s latest announcement of interest rate hikes, there were three layers in particular: The action to raise interest rates, the economic projections issued by Fed committee members, and the words of Fed Chair Jerome Powell.

Let’s take a look at each:

The interest rates

As expected, the Fed raised interest rates by 0.5%. That’s lower than the 0.75% increases at each of the last four meetings, but Powell offered a reminder that it is still “historically high.” After the key interest rate sank to zero during the pandemic, it is now at the highest level in 15 years.

While this increase points to a slowing pace of increases, Fed officials also sent a signal that they expect rates to remain elevated. Projections indicate that many Federal Open Markets Committee members do not see any decreases coming throughout 2023.

So, there may be some letting up on the size of the interest rate increases, but they will be sustained for an extended period, and committee members project the cumulative level of the rates may go even higher. That means the interest rates' effects will have more time to wind their way through the economy, and potentially slow down demand.

The economic projections

The full impact of rate increases has yet to show up in the economy. Data indicates that the job market is still strong, and there is steady consumer spending. But Fed officials believe the numbers will start to speak louder next year.

The median projections of Fed committee members issued Wednesday indicate that unemployment will rise to 4.6% over the next two years, which would be up from its current 3.7%.

The committee members also cut their outlook for GDP growth back to 0.5% for 2023, which was down from 1.2% at the September meeting. With this, growth would hover just above the line of a recession.

When coupled with inflation, these forces on the economy could combine to create a more difficult environment for brands and retailers. Discretionary funds could continue to take a hit. Prices are already high on gas and food. As the Fed raises rates, the cost to borrow goes up on things like mortgages, car loans and credit cards. When people effectively have to pay more to pay down debt, they may have less for other purchases. Meanwhile, businesses will have less available easy capital to grind out tougher times and fund new initiatives. It may mean they have to make cuts. Typically, a strong job market is a key sign of consumer health, so any dent in that could reduce available funds to spend.

Powell on inflation

Inflation readings as recently as Tuesday’s Consumer Price Index print of 7.1% have shown cooling price growth, but the Fed’s goal is to bring inflation down to 2%, and Powell indicated there is still a long way to go.

“The inflation data received so far for October and November show a welcome reduction in the monthly pace of price increases,” Powell said. “But it will take substantially more evidence to give confidence that inflation is on a sustained downward path.”

In the end, Tuesday’s news indicated there may be a path to avoid an outright downturn, but the outlook of Fed officials indicates that it is getting rockier the longer inflation stays high. Even though the median Fed projections show the US narrowly avoiding recession, there are others who believe one will come. In a note issued shortly after the meeting, economists at Bank of America Research wrote that a recession is likely in the first half of 2023.

“While falling commodity and goods prices have likely put the economy past peak inflation in the eyes of the Fed, the committee sees underlying inflation as remaining sticky due to persistent labor market imbalances,” they wrote. “The Fed remains willing to risk a recession in the labor market in order to bring inflation down and, if anything, the December projections suggest that risk has risen, not diminished.”

So in the end, the Fed pulled back on rate increases this month, but painted a picture that shows a longer and potentially more arduous task ahead. When you walk slower, tightropes can actually be more difficult to cross.

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