Why is Fed aiming to raise rates next year?

"It's hard to see a labor market that strong generating 2% inflation."

Jonathan Millar

Senior U.S. economist at Barclays

Federal Reserve officials predicted last week that they'll need to raise interest rates more than they had planned in 2023 to bring down inflation.

Fed rate hikes increase the cost of borrowing money for a car or house and of carrying a credit card balance. They also create a more volatile stock market that could hurt the 401(k) plans of millions of Americans.

So how high will interest rates go in 2023? Some top economists and markets believe they won't go as high as the Fed is forecasting. Here's why.

How much was the rate hike?

The Federal Reserve's final interest rate hike of the year, while historically large at half a percentage point, marked a step down from four straight three-quarters-point increases.

In other words, the Fed is slowing the pace of its flurry of rate increases this year, which are intended to curtail high inflation. That will better allow the central bank to assess the effects of the aggressive moves, including whether they're about to tip the U.S. into a recession next year.

Last Wednesday, Fed officials forecast a total three-quarters-point more in rate increases next year before they pause, bringing the benchmark rate to a peak of about 5.1%, substantially higher than today's 4.3% and the 4.6% peak rate they predicted in September.

Fed Chair Jerome Powell said the Fed has a "ways to go" before it takes a breather and holds rates steady.

Is inflation expected to ease?

To some economists, the hard-nosed stance seems at odds with reports showing inflation easing more than expected the past couple of months.

Consumer prices rose 7.1% annually in November, down from 8.2% in September and a 40-year high of 9.1% in June, according to the Consumer Price Index. That's still well above the Fed's 2% target but a sign of progress.

Yet the Fed revised up its forecast of another inflation measure at the end of 2023 by three-tenths of a percentage point to 3.1% and a "core" reading that excludes volatile food and energy items by nearly half a point to 3.5%.

"What data are they looking at?" asks Tom Porcelli, chief economist of RBC Capital Markets.

Even a normally conservative futures market that predicts interest rate movements doesn't believe the Fed. It figures the Fed will halt its rate increases at about 4.8% as inflation throttles back and the economy worsens, according to CME Group.

Why is the stock market down?

Meanwhile, the S&P 500 index has tumbled about 4% since the Fed announcement, giving back much of the 7.5% gain over the prior six weeks, sparked largely by the encouraging inflation reports and hopes for a less aggressive Fed.

Higher rates mean more pain for the economy and corporate earnings and spur investors to move money from stocks to less risky bonds.

Why does the Fed keep

raising interest rates?

Powell says the Fed welcomes the easing of inflation but it needs to see "substantially more evidence" that "inflation is on a sustained downward path."

While inflation of goods like used cars and furniture is moderating as supply snags ease, Powell said, the price of services such as restaurant visits continues to rise sharply because of persistent labor shortages that force employers to increase wages and, in turn, raise prices.

In November, employers added a healthy 263,000 jobs and average hourly earnings increased robust 5.2% annually, up from 4.7% the previous month.

Jonathan Millar, senior U.S. economist at Barclays, buys Powell's argument.

"It's hard to see a labor market that strong generating 2% inflation," Millar says.

In other words, while inflation has come down, Fed officials don't necessarily believe the trend will last. And so they feel they must raise interest rates higher than planned to make it more expensive for employers to borrow money to hire and invest, damping job growth and wage increases.

Does the Fed want or

need stocks much lower?

Some economists say the Fed is more worried about the buoyant stock market and long-term interest rates that fell sharply as inflation pulled back.

A vibrant stock market makes consumers feel wealthier, prompting them to spend more. And lower long-term rates – such as for mortgages – lead consumers and businesses alike to borrow and spend more.

Such developments bolster the economy but could well fuel more inflation. As a result, the theory goes, Fed policymakers aren't really that gloomy about inflation and the path of interest rates. They just need to say they are in order to dampen the market and goose borrowing costs, helping bring inflation down.

"It's hard to know whether Fed officials really believe their own projections, or whether they are making a point to try and reverse some of the loosening in financial conditions over the past month," economist Paul Ashworth of Capital Economics wrote in a note to clients.

What will the economy

look like in 2023?

Some economists are also puzzled because the Fed's inflation forecast doesn't seem to jibe with its economic projections.

The Fed expects the economy to grow just 0.5% next year, weaker than the 1.2% it forecast in September. And it reckons the 3.7% unemployment will rise to 4.6% by the end of next year, above the 4.4% it had estimated.

Normally, a softer economy and higher unemployment lead to less inflation because fewer shoppers are buying products and fewer employers are hiring, curbing pay increases.

"Those inflation numbers are hard to square," Porcelli wrote in a note to clients.

Millar, however, notes a traditional model that says higher unemployment means lower pay increases and inflation, and vice versa, hasn't held true in recent years. As a result, he says, it may take a much higher unemployment rate to tamp down inflation.

How high will Fed raise rates?

So what will the Fed actually do next year? Despite its forecasts, economists expect the central bank to halt its rate hikes sooner if inflation continues to ease and the economy weakens in coming months.

"We think a slowing economy and progress on inflation will allow the Fed to stop short of that forecast," says economist Nancy Vanden Houten of Oxford Economics. She looks for just another quarter-point rate increase in February, nudging the rate to 4.6%.

"It's hard to see a labor market that strong generating 2% inflation."

Jonathan Millar

Senior U.S. economist at Barclays