What Could Go Wrong for the Federal Reserve in 2023

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Advisor Perspectives
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In some ways, the 2023 economic outlook for the US is locked in. The Federal Reserve’s goal is to push the rate of inflation back down to 2% over the next few years. It will do this by keeping monetary policy tight enough for long enough to restrain economic activity. This will eventually loosen up the labor market sufficiently to push wage inflation down to the 3% to 4% range consistent with their inflation objective.

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Thus, many of the questions posed by market participants are about the margins. How high will the Fed have to raise interest rates? How long will they have to stay there? Will an economic slowdown suffice or will the US fall into recession?

What could go wrong? As I see it, there are three significant risks.

First, economic growth could prove more persistent than expected. Not only did the economy expand much faster during the second half of 2022 than the first, but also the economy will receive additional support next year as federal government outlays surge. The $1.7 trillion government funding bill for 2023 increases defense spending by 10% and domestic discretionary spending by 6%. At the same time, the monthly social security and disability benefit checks to 70 million recipients will rise by 8.7% starting this month. In fact, the increase in recipients’ disposable income will be even larger because Medicare insurance premiums, which are deducted from these checks, will decline this year because the hikes implemented in 2022 turned out to be considerably higher than needed.

Second, monetary policy may not be sufficiently tight to exert much restraint on economic growth. Fed officials believe that a federal funds rate of 2.5% is neutral when inflation is at 2%. So, this would seem to imply that a federal funds rate of 5% (which compares to the current target range of 4.25% to 4.50%) or slightly more should be sufficient to do the job. However, there are number of important reasons why the neutral rate might be higher. For one, because inflation and inflation expectations are elevated currently, then the neutral rate should also be higher. How much so is difficult to judge. Should we use one-year inflation expectations that are still very elevated or longer-term inflation expectations that are still well-anchored?

Another is changes in the balance of investment and saving. If investment demand is elevated — for example, due to costs of shifting production to electric motor vehicles or building greater resiliency to supply chains — then that implies a higher real short-term interest rate. Similarly, if the retirement of the baby-boomer generation and more persistent federal budget deficits reduce the available saving pool, that pushes in the same direction. Recall that prior to the financial crisis, the neutral rate was widely assumed to be around 4% — 2% real (as embodied in the Taylor Rule) and 2% inflation.

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