Powell’s Distinctly Hawkish Forecast

Excessive Fed optimism in 2022 helped open the door for higher inflation. It will be difficult to close.

By Ken Herman

As expected, the Fed recently raised interest rates by 50 basis points (1/2 a percent), but there were also plenty of mostly hawkish surprises in its new forecast. 

A scattering of 2023 forecasts came in as expected, but there was a distinctly hawkish tilt among Powell’s comments. The takeaway regarding median interest rate projections by Federal Open Markets Committee members is 5.1 percent in 2023, 4.1 percent in 2024, and 3.1 percent for 2025, while the balance of his comments again favors the hawks.

The Fed statement predicted modest economic growth, strong employment growth, and an unemployment rate that remains low. Also, “Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures.”

Understanding Inversion

Perhaps the biggest surprise, especially after relatively quiet October and November reports on the Consumer Price Index, is a much higher range of inflation forecasts. Yes, recent inflation news has been encouraging, but there may be a long way to go. The Fed apparently was much too optimistic through September.

By now, most investors have come to understand what an “inverted” yield curve looks like and means. That’s where the 2-year Treasury Note yields are considerably higher than the 10-year Treasury Bond. 

An inverted yield curve historically has indicated a very difficult time for the economy in the coming months—for example, 13 percent inflation in 1979, the dot-com blowup of 2000, the housing crisis of 2008, the COVID-19 impact during 2020, or the currently aggressive rate hikes to force a slowdown after a run of worrisome high inflation.

Recently, the yield on the 2-year T-Note stood at 4.21 percent, while the yield on the 10-year T-Bond was 3.48 percent, for a difference of 0.73 percent, or 73 basis points. This is the widest 2-10 spread since 1980. While one camp argues that such an inversion is a precursor to a hard landing, others contend that it marks a bottom for the economy, followed by recovery. As a reminder, in 1980, the Carter economy was just starting a long run of recessions (for eight of 14 quarters from mid-1979 to end-1982).

What history warns us is that the economy generally suffers a material slowing the year following peak yield-curve inversions, meaning that 2023 may likely prove to be a challenging year for the U.S. economy. We should not be surprised to experience a period of higher unemployment, much lower housing purchase prices, low GDP growth, and lower earnings for the S&P 500. 

For the record, not all yield-curve inversions precede a recession. History also shows that in the year following a steeply inverted yield curve, the stock market of-ten begins the next leg of a secular bull market. If the past is a prologue, 2023 could be a pretty good year for stocks. There are those that argue that the bottom has arrived, and the next bull leg has just begun.

Fear sells headlines, and as we wind down 2022, tensions continue running high. Investors are rattled and on edge from a year wrought with war, politics, bad government, and economic fear. Recession fears have impacted stock prices in a far worse way than the reality of a global COVID pandemic, even as COVID continues claiming human lives. 

That might be a sad commentary on what we hold dear.

About the author

Ken Herman served as the Managing Director of Bank of America Global Capital Markets and was the Mayor of and served on the City Council in Glendora, Calif.