Inflation eases; Fed signals continuing, but potentially smaller, rate increases; ’23 recession remains likely

Has inflation peaked? Could be… but it’s a long way back to 2%

Like a stubborn fever that has finally broken, inflation seems to have loosened its two-year iron grip on the U.S. economy. 

October’s consumer price index—one of the primary gauges of annual inflation—decreased to 7.7% year-over-year, which was the smallest 12-month increase since January 2022. Some indicators—including declining gasoline prices and slowing increases in the producer price index—point to a further decrease in the CPI for November, which will be released on December 13.

Still, the Fed remains undeterred in its campaign to bring inflation back down to its 2% annual target, according to Kiran Kini, CoBank senior vice president and treasurer. Kini says the Fed’s rate increases will continue, though likely in smaller increments, into the first half of 2023, and then pause as they assess the lagged impacts of the increases on the economy.

“The Fed has been clear in its communication for a 50-basis point increase at its next meeting (Federal Open Market Committee) on December 13 and 14,” said Kini. “Fed Chairman Powell confirmed that likelihood in a speech as recently as November 30. He said there has been progress against inflation in parts of the economy that are sensitive to interest rates, such as housing. He also said the Fed is being cautious not to overtighten the economy. They’re focused on finding the right level for rates in the current environment—not too hot, but also not too cold.

“There are a lot of positive tailwinds that should help inflation come down further next year,” Kini continued, “but it will take some time to get back to the Fed’s 2% target.”

Kini also said the Fed has been trying to move the conversation away from the pace of interest rate hikes to what it’s calling the terminal rate, which is the highest interest rate before it begins to bring rates back down.

“At this point, most Fed members are thinking of a likely terminal or destination rate somewhere around 4.5% to 5.25%,” Kini said. “The federal funds rate is currently sitting in the 3.75% to 4% range, so you can see roughly what the Fed sees as the work that remains to be done.”

Kini says the size and timing of the remaining increases will be critical.

“The closer you get to your destination, the more you want to start hitting the brakes,” he continued. “That's what the Fed’s conversation is about. They want to have the freedom of being able to tweak policy instead of keeping the pedal to the metal and risking harm from making too many and too large rate increases.”

Kini still believes that, based on the Fed’s effort to cool the economy, a recession in 2023 remains a strong possibility. 

Keep an eye on these upcoming key economic data announcements:

• Consumer Price Index: December 13
• Federal Open Market Committee: December 14

Newton’s Third Law of Motion: Leveraged loan primary market downturn creates secondary market opportunities

Substantial underwriting losses at several domestic and international money center banks have led to a static lending environment where the primary market for leveraged loans has significantly dried up, leaving many leveraged borrowers out in the cold.

Clarence Plummer, senior vice president, Capital Markets for CoBank, points to continuing difficulties at entities such as Swiss banking giant Credit Suisse, which is forecasting a $1.6 billion quarterly loss. Also, large underwriting losses at several U.S. money center banks stemming from high-profile leveraged deals, including Twitter, have caused them to pull back on their leveraged loan lending and participations (also see Power & Energy Market Focus below).

“It’s an interesting market that seems to be operating according to Newton’s third law of motion—every action has an equal and opposite reaction,” said Plummer. “It has created a great opportunity for CoBank and the Farm Credit System because we have capital, specific industry sectors that we're focused on and an excellent relationship management orientation because our customers are our owners. 

“We're seeing more opportunities with our borrowers, who previously would consider us along with other lenders,” Plummer added. “The traditional lenders are either backing off or taking less of a participation, and it creates a great opportunity for us to come in, help them and serve our mission.”

But wait, there’s more! There’s also the secondary loan market, which arranging banks frequently use to distribute unsold inventory.

Paul Trefry, who works as head of loan trading and asset sourcing at CoBank, says the losses from commercial banks’ leveraged loan activities have led to opportunities in the secondary market, which also are benefiting CoBank and the FCS.

“When the market was very active earlier in the year, loans would often sell above par,” said Trefry. “With less activity and fewer bidders in the marketplace, we can now pick up loans for par, or slightly less. 

“For example, we recently looked at a telecom transaction funded by a large commercial bank,” Trefry continued. “Previously, if a deal like that came to market, we might be willing to pay par, or slightly more. 

“By actively following the bids and asks and maintaining price discipline, and with the FCS and CoBank working together, we can extract value from the secondary market,” concluded Trefry.