FED DOWNSHIFTS, but Inflation Risks Remain

BY: ROBERT DIETZ

Further slowing its pace of tightening monetary policy, the Federal Reserve on Feb. 1 raised the federal funds target rate by 25 basis points, increasing that target to an upper bound of 4.75%. This marked a smaller increase after four previous 75 basis-point hikes and a decelerated 50 basis-point increase last December. Although monetary policy will continue to tighten, the end is in sight, with a final 25 basis-point increase expected in March. However, the Fed has clearly communicated it will hold at these elevated rates through much, if not all, of 2023, as progress on inflation is realized. We do not expect an easing of the federal funds rate until 2024.

Moreover, for some economists, the labor market continues to present inflation risks. After a declining yet positive pace for five consecutive months, total nonfarm payroll employment accelerated and increased by 517,000 in January, with the unemployment rate reaching a 53-year low at 3.4%. Although many economists fret about the Phillips curve (which posits inflation rises as the unemployment rate declines), this relationship has lost some of its explanatory power in recent decades. Nonetheless, the strong January job gains — combined with a rise in the number of open, unfilled jobs for the overall economy (11 million) — may worry some monetary policymakers about a reversal of inflation trends and encourage additional rate hikes beyond March.

The labor market data are consistent with the relatively strong showing for economic growth in the fourth quarter of 2022. Real gross domestic product (GDP) increased at an annual rate of 2.9%, following a 3.2% increase in the third quarter. In 2022, real GDP contracted in the first half and then rebounded. NAHB is forecasting declines for the first two quarters of 2023.

The expectation of softening GDP growth combined with the downshift for the Fed have caused mortgage interest rates to retreat, benefitting housing demand. Since early November, mortgage rates have fallen by approximately 100 basis points to roughly 6.1%. Combined with the use of builder sales incentives, this decline caused new home sales to improve. Sales of newly built single-family homes increased 2.3% in December to a 616,000 seasonally adjusted annual pace. However, this is 26.6% below the rate from a year ago.