The Federal Reserve (Fed) raised borrowing costs again today amid evidence that the economy is feeling the effects of eight consecutive rate hikes. The 25-basis point (bp) increase lifted the Fed’s short-term interest rate target to a range of 4.5% to 4.75%, its highest level since 2007.

The Fed has pursued an aggressive inflation-fighting campaign, lifting interest rates by 4.5 percentage points in 11 months. In addition to fueling severe market volatility, this rapid and significant tightening of monetary policy is finally having the Fed’s desired effect. Inflation has peaked and growth has slowed, but the tradeoff is heightened recession risk.

Even though an imminent recession may be unsettling, it’s important to remember that diversified portfolios are generally designed for changing economic scenarios. Recessions are normal — and unavoidable —components of economic cycles. We believe emphasizing quality and discipline in your investment portfolio remains a prudent strategy regardless of the economic backdrop.

Rate-Hike Lag Time Puts Economic Growth in Jeopardy

Month-over-month inflation rates have slowed considerably in recent months. But annual rates, which have moderated from peak levels, remain elevated and well above Fed targets. We expect year-over-year inflation rates to gradually trend lower this year.

Despite moderating inflation rates, we believe the extended period of high inflation combined with restrictive monetary policy ultimately will trigger a recession. But the depth of the downturn remains uncertain, largely due to the long and variable lag associated with monetary policy’s economic fallout. Persistently high inflation has not afforded the Fed the time to gauge the actual impact of its previous rate hikes.

Prior rate hikes eventually may be sufficient to ease prices. But consistent above-target inflation rates have worried the Fed and fueled its relentless tightening.

History Suggests the Fed Isn’t Finished

With the Fed downshifting to a 25-bps rate hike and some economic indicators slowing, we suspect the central bank’s tightening campaign is winding down. But with inflation still above the Fed’s comfort zone and the job market still robust, we don’t think policymakers will rush to declare victory.

The Fed appears more comfortable with the consequences of overtightening than the dangers of persistently high inflation. The central bank wants to make sure inflation’s slowdown continues before changing course. And a labor market downturn, which likely would coincide with a recession, may be necessary to safeguard that trend.

History also provides perspective on Fed tightening policy. Since 1973, the Fed has never settled for a negative real federal funds rate (federal funds rate minus inflation). The peak federal funds rate has always exceeded the inflation rate, and as Figure 1 demonstrates, we’re not there yet.

Rate Cuts in 2023 Seem Unlikely

The futures market currently forecasts another 25-bps rate hike in March, pushing the federal funds rate target to a range of 4.75% to 5%. By September, the futures market expects the first of two Fed rate cuts this year. In this scenario, the federal funds rate target would end 2023 in a range of 4.25% to 4.50%.

We agree with the market’s rate hike forecast for March. However, we don’t expect the Fed to pivot and cut rates this year.

Instead, drawing on the painful lessons from 1970s monetary policy, the Fed will likely hold rates higher for longer. We expect a lengthy pause, giving central bankers time to assess the economic consequences of their aggressive year-long tightening campaign.

In our view, this approach would help secure the Fed’s inflation-fighting credibility. But we also believe the Fed’s steadfastness eventually should tip the economy into recession.

Economic Indicators Suggest Recession Is Looming

Recent economic data confirms the economy is slowing. The U.S. manufacturing sector has been contracting since November, while the services sector has been declining since July. Monthly retail sales fell in November and December, and companies cut temporary workers in December for the fifth consecutive month.

In late January, the Commerce Department reported that the U.S. annualized gross domestic product (GDP) slowed to 2.9% in the fourth quarter. GDP was 3.2% in the third quarter. Also, in late January, the Federal Reserve Bank of Atlanta projected that the annualized GDP rate would slip to 0.7% in the first quarter.

Healthy Job Market Muddles Fed’s Mission

While various economic data indicate a slowdown, one critical metric remains robust. The job market has stayed surprisingly resilient, complicating the Fed’s inflation-fighting efforts.

The U.S. unemployment rate ended 2022 at 3.5%, a 50-year low. However, fewer Americans are working now than before the pandemic. The labor force participation rate remains lower than its long-term average, and the number of job openings continues to exceed the number of job seekers.

This supply-demand imbalance has increased the cost of labor, while wage gains have helped support consumer spending. This combination is partly to blame for the still-high inflation rate. Meanwhile, recent high-profile technology and finance industry layoff announcements indicate a potential momentum shift in the labor market.

Finding Potential Value in Higher-Quality Bonds, Stocks

Given our economic expectations, our investment teams are generally focusing on higher-quality securities. In our view, certain defensive characteristics may help portfolios weather a recession.

Our Fixed Income team believes higher-quality securities, including U.S. Treasuries and higher-credit-quality corporate bonds, may merit consideration. Additionally, the team believes extending duration may offer value, as interest rates typically fall heading into a recession. Maintaining exposure to inflation-protected securities also may help, as inflation likely will remain elevated.

Our Equity managers believe companies with higher profitability and healthy balance sheets may offer attractive potential in an economic downturn. Companies in more defensive sectors, such as utilities, health care and consumer staples, and dividend-paying stocks, tend to offer value as economic conditions weaken. Additionally, companies with dependable, secular earnings growth tend to outperform during economic downturns.

Stick With Your Portfolio Plan

As always, we encourage you to remain disciplined and avoid reacting to short-term market swings. In our view, investing across multiple asset classes and sectors focusing on risk management is the prudent approach in the current market environment.

It’s also important to remember that market dislocations often create opportunities. We suggest investing with experienced professionals who have the insights, conviction and discipline to recognize and potentially capitalize on attractive opportunities when they’re significantly undervalued.