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Has the Fed Beaten Inflation? Why High Prices Will Still Be a Problem in 2023.

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About the author: Peter Cramer is a senior managing director and senior portfolio manager, insurance asset management at SLC management. This commentary reflects his personal opinions.

The path of risk assets in 2023 depends on how far the Federal Reserve is willing to go in its interest-rate hikes to rein in once-in-a-generation inflation. But believing that the Fed has inflation under control today could be a painful mistake.

As we saw from the overreaction to Fed Chairman Jerome Powell’s speech on Nov. 30, investors are so caught up in the anticipation of a Fed pivot that they have overlooked the more important part of his comments.

While Powell indicated in his speech that the Federal Open Market Committee would soon begin “moderating the pace of rate increases,” he also said “it is likely that restoring price stability will require holding policy at a restrictive level for some time.” This is a far cry from the pivot that bullish market participants desire. He will probably raise rates again by 50 basis points, or 0.5%, in December.

Fed-fund futures suggest that the market thinks inflation will fall sufficiently over the course of the next six months to allow the Fed to pivot to cutting rates by June 2023. This type of pivot would result in a short-lived period of economic pain from high rates, followed by a return to relative normalcy by mid-2023, and would clearly be positive for risk assets.

However, the Fed may need to be even more aggressive next year to get inflation under control, pushing past 5% on the fed-funds rate. Markets underestimating that risk could lead to a painful correction in risk assets. There are several inflationary market forces that Powell will have to grapple with.

Despite a cooling housing market, the 12- to 18-month lag between home prices and rents (which count for a third of the consumer price index) means that shelter will be a major inflation tailwind next year. The S&P CoreLogic Case-Shiller national home price index peaked in July, giving us higher owners’ equivalent rent through January 2024. And even if home price increases slow from the current 10.6% year over year to 5%, say, that is still a historically high growth rate.

And while mass firings at tech companies like Twitter may give the anecdotal impression that unemployment is ticking up, the latest jobs report suggests that there is still not much slack in the U.S. labor market. Demand for labor will continue to put upward pressure on wages in 2023, which already increased by 5.1% this year, staving off the significant slowdown in consumer spending needed to cool inflation.

Meanwhile, many of the disinflationary forces that helped to propel the U.S. economy to below 2% inflation over the past three decades have reversed. Namely, globalization allowed companies to find the cheapest way to manufacture products through lower wages in developing markets. The erosion of global trust and the Balkanization of trade is now causing issues in those supply chains, prompting more manufacturers to onshore production.

The decline in global security is also driving an uptick in military spending, not least because the war in Ukraine reminded Europe of the threat from Russia. Several North Atlantic Treaty Organization countries have committed to increasing military spending to be closer to the current target 2% of gross domestic product, equating to trillions of dollars for military goods and services. Defense isn’t a sector that scales quickly, and demand for materials and high-tech components could place extra pressure on global supply chains.

In Germany, higher energy costs from an overreliance on natural gas could cause its manufacturing industry to stall over the winter. The country is rapidly building liquefied-natural-gas infrastructure to increase its energy security, with one terminal in the North Sea already completed, but importing that gas will probably be inflationary.

Similarly, inflation will be driven by government spending plans to help soften the blow to consumers of higher energy bills over the winter. European Union governments have committed more than 550 billion euros ($571 billion) to subsidize energy costs, according to economic think tank Bruegel.

If the Fed ultimately keeps rates higher and for longer than the market expects, that will keep the proverbial foot on the throat of the global economy (and risk assets), driving spreads on corporate bonds wider and equity values lower. Investing in this uncertain environment means protecting the downside on riskier assets. Diversify your portfolio by owning more Treasuries, sectors with more U.S. than foreign exposures (in particular, municipals), or cash until the market has better priced the Fed’s moves.

The Fed may come round to the realization that it needs to increase its inflation target to above 2%. If that happens, we will then probably see higher rates in the long end of the curve (10 to 30 years). That will be a boon for pension plans and life insurance companies that typically invest in longer-duration securities but will require a dramatic repricing of long Treasury yields.

In the short term, don’t get carried away by the tide of optimism. The reality is that we still have a bumpy ride ahead.

Guest commentaries like this one are written by authors outside the Barron’s and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to ideas@barrons.com.

Credit: marketwatch.com

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