Much of 2023 saw markets continue to be consumed by the level and trend in inflation. The Federal Reserve, government officials, consumers, and market participants hung on every inflation reading, eagerly watching for continued declines from the multi-decade peaks seen in 2022. Despite progress on inflation since July 2022, for much of 2023, concerns remained about the possibility for prices to turn around and head higher, posing a risk to the long-run sustainability of the economy and consumer’s finances. Thankfully, it now appears as though we may be able to declare victory on inflation and start agonizing about the direction and trend of another key economic statistic...interest rates.
Throughout most of 2023, the Federal Reserve worked to contain inflation by slowing the economy, and the primary tool to achieve this goal was higher interest rates. Higher rates were intended to slow the level of economic activity enough to help ease inflationary pressure without causing the economy to fall into recession. Over the course of 2023, the United States avoided a recession as the economy grew at a rate above 2% annualized in each of the first two quarters before posting an eye-catching 4.9% annualized growth rate in Q3. Presently, the Atlanta Fed estimate of Q4 GDP growth is a very healthy 2.2%, which would confirm no recession took place in 2023. The employment picture also indicates successful avoidance of a recession, as the United States added 225k jobs on average each month (for a total of almost 2.7 million jobs) in 2023, and the unemployment rate ended the year at 3.7%.
With inflation continuing to trend down toward the Federal Reserve’s longer-run target of 2%, the Fed signaled in December that they were unlikely to raise the Fed Funds Rate from the current target range of 5.25%-5.50%. This rate, which acts as the reference rate for most consumer and commercial interest rates in the United States is a key tool in the Federal Reserve’s arsenal for fighting inflation. When the Federal Reserve pivoted away from further rate hikes, market participants turned their attention to the next move in rates, which they anticipated would bring rates down from the restrictive levels of today and start cutting rates. The Federal Reserve released its forecast for rates in 2024, and anticipates reducing rates by 0.75% by the end of 2024. However, the market started to trade in a manner that it anticipated rates declining by 1.50%. As a result, we all instantly had a new set of statistics to obsess over, which looks likely to drive both stock and bond market fluctuations over the first half of the year.
We feel that the market may have gotten too optimistic about the pace of interest rate declines over the course of 2024. In an environment where growth is expected to slow but stay positive, we see little reason to assume the Fed will move to reduce interest rates so quickly. Lower rates would help accelerate economic activity, but with inflation still above the Fed’s long-term target of 2%, the risk of reigniting inflation by cutting rates aggressively is not a course of action we anticipate the Fed taking. We believe that as every clue to the next move in rates is scrutinized, the rate outlook will likely be a key source of volatility for the coming year. We remain committed to responding to market volatility with a carefully measured response, as we have in the past. Our focus remains on holding high-quality assets in all portfolios and avoiding excessive risk while economic volatility remains elevated.