Stock and bond markets struggled last year as the Federal Reserve hiked rates aggressively throughout the year. The S&P 500 fell over 18%, while the US Aggregate Bond Index fell over 13% – its worst year on record. The Federal Reserve projected slow and steady interest rate hikes to begin the year, but raised rates much faster as the year progressed, ending at a Fed Funds rate of 4.25%-4.50%.
The Fed is trying to slow demand in the economy, which will help bring inflation down from the highest levels since the early 1980s. Expectations are that the Fed will hike rates a few more times this year, but the hikes will be less sizable at 0.25% each.
Inflation showed signs of moderating throughout the second half of 2022 after reaching 9.1% in June, falling each month to finish the year at 6.5%. Stocks and bonds reacted negatively to the Fed’s actions as aggressive rate hikes increase the probability that Fed policy becomes too restrictive and will lead to a recession.
The Fed continued its aggressive rhetoric each time the market tried to rally last year, so markets will be watching for the Fed to tilt to a more accommodative posture in 2023. A Fed pivot could take pressure off the market and lead to a sustainable rebound.
Volatility should remain elevated in markets this year around Fed policy and inflation reports, which will determine if the Fed rate increases are having their intended effects without slowing the economy too much.
Consumer spending remained robust in 2022, helping businesses keep their profit margins high. It is uncertain if consumers will be able to keep up their spending pace throughout 2023, or if inflation will put a dent in spending causing an economic slowdown.
The Fed remains in a difficult position fearing that if they let off the gas too soon, inflation will rebound. The Fed also acknowledges raising rates too high can lead to unintended consequences, including a recession. The Fed indicated they are more concerned with the risks of not doing enough than the risks of doing too much.
The stock market usually bottoms well before the economy so while economic conditions may continue to slow for the near future, it will be important to monitor monthly inflation readings to determine if the Fed is winning the battle.
Keith Bonjour, CFP®, is vice president, portfolio manager of Northwest Bank’s Investment Management Group. Mr. Bonjour can be reached at kbonjour@northwestbank.com.
