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Does the Fed have it wrong?

For most of 2022, financial markets were laser focused on one thing: Inflation.

But late last year, an important shift in the narrative occurred. Markets became less worried about inflation and more concerned that the Federal Reserve's interest rate hikes were putting the U.S. economy into a deeper recession.

The Federal Reserve is our country's central bank. It oversees, and to a degree, manages the U.S. economy. The Fed steps in during times of crisis to provide stimulus. It also takes action when the economy is running hot with demand outpacing supply, leading to higher prices of goods and services.

To combat this, the Fed can raise interest rates to discourage consumer and corporate activity. This effectively slows the economy. As we saw in 2022, that can be bad for stock and bond market returns but necessary to curb inflation.

Since the COVID-19 pandemic began in March 2020, the response from the Federal Reserve has come in three phases.

The first took place during the early months of COVID. With the economy in chaos and financial markets in freefall, the Fed stepped in to provide stability. It cut interest rates and began purchasing $120 billion of government bonds and mortgage-backed securities each month.

The second phase occurred toward the end of 2020 and for the entirety of 2021. The Fed continued its monthly securities purchases, even after the dust had cleared. This continued until March 2022.

It's easy to play Monday morning quarterback. But providing that much stimulus each month to an economy emerging from the pandemic with strong pent-up demand and consumer balance sheets was a major policy error. Doing so was a cause for some of the economic excesses that we saw over the past two years.

We're now in Phase 3, as the Fed uses its available tools to slow the economy and fight inflation. What has resulted is the Federal Reserve's most aggressive interest rate-hiking campaign to date. The central bank has raised rates faster than its past tightening cycles in 1983, 1988, 1994, 1999, 2004 and 2015.

The Federal Funds rate has been raised from 0.25% to 4.5% in less than a year. With two more rate increases forecasted in 2023, the Fed is showing no signs of letting up.

The good news: These rate hikes are working. The November Consumer Price Index (CPI) report showed that consumer inflation declined for a fifth straight month, falling to 7.1%. That's down from the post-pandemic CPI peak of 9.1% in June. The Producer Price index (PPI) has trended lower over the same period as well, with key business costs like shipping, trucking, production, new orders and inventory declining.

Wage growth has trailed increases to the cost of living. The housing market has slowed. Consumer spending is down. Even holiday shopping came in under expectations. Those are all signs of falling inflation.

The bad news: The Fed may be going too far. Further rate hikes will significantly increase the odds of a recession and likely eliminate hopes for a soft landing. If inflation truly has peaked and continues to decline, are additional interest rate increases needed?

As we move forward, the question on the mind of many investors is whether the Fed will pull back and moderate its aggressive pace. The Fed's upcoming decision on Feb. 1 and again on March 23 will have important implications for the economy in 2023 and beyond.

• Jim Platania Jr. CFP, CPA is a Wealth Management Advisor at Platania Financial Inc., located at 2 W. Northwest Highway, Arlington Heights, IL 60004. He can be reached at info@plataniafinancial.com or by phone at (847) 870-7526. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Securities and advisory services offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC.

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