Will The Monetary Policy Ease Its Impact in 2023?

In 2023, markets are expected to be less susceptible to the risk of rising interest rates. This is due to the moderation of aggressive tightening, which has impacted markets for most of 2022, as inflation has slowed down recently. Although a pause in tightening is more likely to occur in 2023 than a pivot to easing, the monetary policy may not become a major catalyst for a market rebound given the challenging macro environment.

Slowdown of the Pace of Interest Rate Hikes by Central Banks

Recently, several central banks have decided to slow down the pace of tightening in their final policy meetings of 2022. For instance, the Federal Reserve, European Central Bank (ECB), and Bank of England (BOE) each raised their main policy rates by 50 basis points (bps), down from 75 bps at their previous meetings. However, the Bank of Japan (BOJ) remained an exception as it surprised markets by widening the target range of the ten-year Japanese government bond yield to 50 bps (from 25 bps) around zero, as part of its yield curve control policy.

Impact of Slowing Inflation

The slowing down of the pace of interest rate hikes by most central banks is a result of the economic impact assessment of this cycle's rapid tightening and the recent slowing down of inflation. In the United States, the consumer price index (CPI) rose 7.1% year-over-year in November, down from a four-decade peak of 9.1% in June, and the core CPI has eased more than expected for two consecutive months. Although the inflation picture in Europe remains more precarious there are signs that inflation may have peaked.

Market Expectations

The recent reduction in the pace of interest rate hikes was widely anticipated due to the recent softening in inflation. The odds of a 50-bp hike by the Fed in December increased from as low as 22% in mid-October to above 80% by last week's meeting. During this period, investor sentiment improved, with both equities and bonds rallying, and the dollar weakening. However, investor sentiment has soured since last week's policy meetings, as investors may have over-anticipated a rapid decline in inflation and lower peak rates.

While the recent data shows a reduction in inflation, most officials at the Fed, ECB, and BOE still believe that inflation has a long way to go to reach their price targets. The Fed revised up its median inflation forecast for 2023 and most officials projected that the Fed will need to raise the Fed funds rate from its current target range of 4.25% to 4.5% to above 5%, up from its median projection of 4.6% in September. The ECB and BOE followed the Fed's lead by raising their inflation projections for 2023 and signaled additional rate increases to sustainably bring down inflation.

Inflation Persists Despite Recent Moderation

Inflation remains above most central banks' inflation targets, and it is expected to be slow to decelerate in 2023. Inflation has moderated in some segments of the economy as supply bottlenecks have improved, but other sources of inflation remain strong. For instance, US shelter prices rose 0.6% month-over-month in November, and a broader measure of "sticky inflation" sources continued to accelerate. Strong wage growth, which is supported by persistent labor market strength, could offset any decline in other sources of inflation in 2023 unless there is a significant softening in the economy.

Even if the Fed increases rates by another 75 bps in 2023, as the latest projections suggest, it will have only raised rates by a total of 500 bps this cycle, which is only an average degree of tightening compared to previous cycles. It has typically taken significantly more tightening than usual to bring down inflation when it is elevated. Furthermore, history suggests that it would be unusual for the Fed to be able to cut rates by the end of 2023 without a rapid decline in inflation. This is because the Fed has continued raising rates until inflation has fallen below the funds rate in every tightening cycle but one, and it hasn’t started cutting rates on average until five months after its last rate hike.

Monetary Policy and Market Rebound in 2023

Therefore, it is safe to say that monetary policy will remain a headwind for markets in 2023, as a pause in tightening is more likely than a pivot to easing. This is because inflation will be slow to further decelerate, causing the Fed, and most other central banks, to hold rates higher for longer. Inflation remains well above most central banks’ inflation targets, and it is expected to be slow to decelerate next year. Although inflation has moderated in some segments of the economy as supply bottlenecks have improved, other key sources of inflation remain strong. For example, US shelter prices rose 0.6% month-over-month in November, and a broader measure of “sticky inflation” sources continued to accelerate. Strong wage growth, supported by persistent labor market strength, could offset any decline in other sources of inflation next year, unless there is a significant softening in the economy.

In conclusion, while the recent slowdown in inflation is a positive development, it's unlikely that monetary policy will become a major catalyst for a market rebound in 2023. Inflation remains well above most central banks' inflation targets, and it's anticipated to be slow to decelerate next year. Strong wage growth, supported by persistent labor market strength, could offset any decline in other sources of inflation unless there is a significant softening in the economy. The Fed, ECB, and BOE have revised up their inflation projections for 2023 and signaled that additional rate increases may be necessary to bring down inflation. While a pause in tightening is more likely than a pivot to easing, it will take time for inflation to decelerate, causing central banks to hold rates higher for longer. As a result, monetary policy is unlikely to provide a tailwind for markets in 2023, and investors will need to navigate the macro environment, which remains challenging.