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By EV Forward

Expect a Year of "Long and Variable Lags"

2023Caronkeypoints

Fed Policy Will Continue to Drive Asset Prices in 2023

Monetary policy will continue to be the key driver of asset prices in 2023.

Fed policy has the potential to cut back earnings, increase default risks, widen credit spreads and increase the chances for a recession. Why? Well, as stated by the Fed, rate hikes work, and there are often "long and variable lags" between a monetary policy action and its impact on the economy.

The Fed's mission is to help lower inflation to its 2% to 2.5% target and keep it there, durably. Will it work in 2023? If not, what's at stake?

Inflation Remains Stubbornly High

The pandemic caused supply shortages and excess demand driven by fiscal stimulus. In turn, the Fed tightened monetary policy to address skyrocketing inflation.

The Fed initially believed supply shortage inflation would melt away as the pandemic ended and supply chains reopened. Goods inflation did fall sharply late in 2022, but service sector inflation remained stubbornly high and became more difficult to tame.

The culprit? A tight labor market kept wage inflation elevated. The Fed turned its attention to weakening the labor market-enough but not by too much.

Fed's Delicate Balancing Act

The Fed's dual mandate has been full employment and stable prices. It does not want to sacrifice jobs to tame inflation but, instead, delicately balance the two. It has indicated a plan to increase policy rates to around 5% and hold them there for an extended period, even if the economy slips into a mild recession.

We expect any recession to be mild because the jobs market will likely remain strong. Quite simply, it's difficult to expect a deep recession with such a robust labor market.

Risks remain. Holding policy rates high while the economy is slowing can result in lower earnings, falling margins and rising default risks, all of which can have adverse effects on equity and credit valuations.

Cost-Benefit Analysis of Policy Actions

Cost is measured by job losses. Benefit is measured in terms of quality future growth with lower inflation.

The Fed believes that in 2023 it may have a window to tame inflation by keeping policy rates higher for longer. Economic growth and asset valuations may be collateral damage-but worth it. In the Fed's view, aggressive action now may mean eliminating the need to act more aggressively later, creating greater damage

With peak inflation likely behind us, high-quality bonds may benefit, while riskier assets and lower-quality credit may suffer. However, if the Fed's plan to durably stem inflation works, asset valuations may benefit over the longer term.

Be nimble and prepared to adjust investment positions as events unfold in 2023.

Jim Caron
Senior Advisor, Fixed Income Team

In January 2023, Jim Caron will take on a new role as Co-Chief Investment Officer, Co-Deputy Head and Senior Portfolio Manager of Global Balanced Risk Control (GBaR).

The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.