Federal Reserve Outlook for January - Interest Rates, Sentiment
Gather around, Fed watchers, it’s going to be a challenging month with the first of the central bank’s annual meetings coming up January 31 to February 1.
The macroeconomic outlook is clouded by concerns over the US manufacturing sector which contracted for a second consecutive month in December, according to the ISM Manufacturing Purchasing Managers Index (PMI). It was the lowest reading since February 2016, not including the curve-bending implosion triggered by the pandemic in April 2020.
The downturn in December tracked the weaknesses in new orders and production output seen in November with the difference of an upturn in employment which moved into positive territory. The segment employs close to 10 percent of the entire US workforce and the average compensation for workers is nearly 9 percent higher than for the rest of the private sector, meaning that household savings and spending from employees is a significant contributor to GDP.
Economic vulnerabilities
What happens when the manufacturing sector contracts?
Like the housing sector, the manufacturing sector accounts for a major part of economic activity, meaning that vulnerabilities can damage or even cripple growth. Manufacturing contributes nearly one quarter of total Gross Domestic Product (GDP) activity in the US, including direct and indirect values.
At the beginning of last year, the Federal Reserve anticipated the downturn in output seen in 2022 and forecasted that real GDP growth would step down in 2023 even as labour conditions remain tight. At the end of 2022, the Fed reiterated that “economic growth was still forecast to slow markedly in 2023,” according to the FOMC Minutes, December 2022.
The Fed’s forecast became a self-fulfilling prophecy. Part of the slowdown stemmed from the restrictive monetary policy that started in the first quarter of 2022 and tightened further throughout the year.
At the beginning of the new year, the Fed’s hawkish policy is not expected to change in the short term, an impression that’s strengthened by a quote from the Minutes: “No participants anticipated that it would appropriate to begin reducing the federal funds rate target in 2023.”
A restrictive monetary policy is likely to persist until inflation is on a ‘sustained downward path to 2 percent’. This will take some time although inflation is projected to decline markedly over the next year, according to the central bank.
Returning to the manufacturing sector, the rising cost of business loans and inflation pressures are significant barriers to funding new ventures and investing in job creation. On the other hand, supply bottlenecks and costs of raw materials have eased and the December performance in the jobs sector was better than expected, according to the ADP Employment Change report.
What to expect from the next Fed meeting
The last interest rate hike was 0.5 percent and the next one is seen at the same level, taking overall guidance to 5 percent.
Prior to the decision due for release on February 1, market sentiment could fluctuate during January depending on the Fed’s rhetoric during speeches and interviews. Chairman Jerome Powell is due to give a speech in Stockholm on January 10 that could include off-the-cuff comments to the media, for example. The USD might see support provided the Fed’s rhetoric is in line with the market’s expectations for an interest rate hike at the next meeting.
Other than the run up to the Fed’s rate decision, US data to watch in January includes the MBA Mortgage Applications figures for the week ending January 6. Last seen at minus 10.3 percent, the sharp drop in mortgage applications reflected the effects of rising interest rates which could in turn knock onto the banking sector’s revenues if the trend continues in the first quarter.
Fast approaching on January 12 is the US Core Inflation Rate release for December. Seen at the level of 5.9 percent compared with 6 percent in November, core inflation is the Fed’s main benchmark for evaluating price stability. Headline inflation is seen at 6.9 percent compared with the previous result of 7.1 percent in November. If inflation didn’t meet the market’s expectations and rose instead of falling in December, this could increase the chances of a more hawkish interest rate policy. A steeper than expected decline in inflation might mean the Fed will maintain a more moderate stance in the short term.
Finally, the preliminary Michigan Consumer Sentiment report for January is due out on January 13. Expected at the level of 60.5 compared with 59.7 previously, the important economic benchmark covers consumer sentiment, which accounts for approximately two-thirds of GDP in the US. Provided the indicator rises in line with expectations, this could support other more promising bright spots like the employment sector. There’s a chance that the benchmark index could disappoint expectations, dimming the outlook for growth.
Volatility
Will January be more volatile or less volatile compared to December when it comes anticipating the Fed’s next move? Stock markets ended last year in a bearish mood made worse by global recession fears and sell-offs in key sectors from technology to energy. Since inflationary headwinds have blown into 2023 from 2022, investors and traders should prepare for adjustments in the interest rate environment and watch for the effects of uncertainty on sentiment.
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