Key takeaways:
- High inflation forced the Fed to dramatically step up the size and pace of its interest rate hikes during the quarter with guidance for more of the same for the rest of year.
- The prospect that the Fed would need to trigger a deep recession to get inflation under control contributed to substantial volatility across asset classes.
- A number of headwinds to economic growth are developing in Q3 that should make the Fed’s job a bit easier. Early signs in inflation-related data also point to an easing of inflation in the second half of the year.
- Long-term inflation expectations remain well anchored, implying that the market has confidence in the Fed’s aggressive approach.
“Economic expansions don’t die of old age they are murdered by the Federal Reserve.”
-Rudi Dornbusch
Market Update:
While the war in Europe dominated markets in Q1, the only war that mattered to markets in Q2 was the battle that was heating up between the Fed and inflation. During the quarter, surging prices forced the Fed to pivot to dramatically more aggressive tightening. This in turn drove mortgage rates up, sent the dollar soaring and led to significant stock market losses. Combined with the sudden drop in fiscal spending this year and record-low consumer sentiment, the economy appeared to be rapidly decelerating into the second half of the year. The question on everyone’s mind that has been roiling markets is whether the Fed will trigger a deep recession to address the highest inflation we’ve seen in more than 40 years.
As we discussed in our last communication, with the outbreak of war in Europe, an historically tight labor market, and persistently high inflation numbers the Fed began moving away from its belief that inflation would be transitory. By the end of the first quarter, several Fed members were suggesting that the central bank could be behind the curve and was considering accelerating its gradual .25% hikes to .50% hikes over the coming meetings. In Q2, that urgency became a reality as red-hot inflation exceeded 9% year-over-year in June, prompting the Fed to hike rates by a full .75% with promises of more of the same in coming meetings. Internal projections showed Fed members expecting further increases totaling 1.75% this year and another .50% in 2023. This would take the fed funds rate to 3.5% by year end and as high as 4.0% by the end of next year. Further tightening financial conditions, the Fed continued to reduce its huge $8.5 trillion bond holdings, a process that started in June at a clip of $47.5 billion per month and that will be adjusted upward to $95 billion monthly by September.
While the economy shrank by 1.6% in the first quarter of 2022, monthly data suggest activity picked up a bit in Q2 as the Omicron variant ran its course and consumer spending picked up in “reopening” segments of the economy like travel, restaurants, leisure, and entertainment. Coming into Q3 however there are several headwinds to growth that will likely slow the post-pandemic economic momentum. Following the massive fiscal support totaling more than $5.6 trillion that was distributed over the course of two years, the economy must now reckon with a huge fiscal drag. The end to stimulus checks, enhanced unemployment benefits and child tax credits among other programs that were intended to support the hardest hit households during the pandemic will bring the federal budget deficit from 12.4% of GDP in 2021 to less than 4% of GDP projected this year. This would represent the single largest decline in government spending since the end of World War II when government wartime spending came to a sudden end. Further dragging on growth, significantly higher mortgage rates began to weigh on the housing market and a surging dollar led to weakness in exports. Finally, falling stock prices and high inflation soured consumer confidence – now the lowest in recorded history – all contributing to an increased risk that the U.S. economy slips into recession in the second half of the year.
A number of bright spots in the economy, however, should simplify the Fed’s battle against inflation and allow it to avoid the prolonged nightmare that developed in the 1970s and culminated in punishingly high interest rates and a deep global recession in the early 1980s. First, the labor market is as healthy as it has been in 50 years, with unemployment at 3.6%. Furthermore, there remains significant excess demand for labor, with approximately 5.5 million more job openings than there are unemployed workers. This dynamic will give the Fed immense latitude (and therefore credibility) to favor price stability over its other mandate to promote maximum employment. Today the employment picture gives the central bank ample room to hike interest rates and curb growth without having to be too concerned about its employment goal for the foreseeable future. This compares to the conundrum in the 1970s wherein the Fed was perennially forced to back off its promises to fight inflation due to soaring unemployment. Furthermore, the tradeoff between unemployment and inflation is better understood today than it was in the 1970s; the economic damage of high inflation is simply deeper, more widespread, and more permanent than the offsetting benefits of having replaced the 20.4 million jobs that were lost during the pandemic. This cost-benefit analysis overwhelmingly favors price stability over employment and particularly so at a time of maximum employment and rising wages. We believe that this largely explains why long-term inflation expectations remain so well anchored despite soaring prices in the short term. Markets believe the Fed has every reason to get inflation under control as quickly as possible.
The second bright spot in the economic picture maybe even more important. Many precursors to inflation are beginning to cool off, indicating that price pressures will begin to ease significantly in the second part of the year. Things like energy prices, commodities, airline fares, and shipping costs which soared during the pandemic have begun a fairly dramatic decline in recent months. Furthermore, supply chain disruptions are beginning to clear up and production is picking up, allowing it to catch up with the huge post-pandemic demand. Finally, the decelerating growth picture in the second half of the year will also help ease demand and take further pressure off prices.
While these dynamics may not allow the fed to avoid triggering a recession in its fight against inflation, it does increase the chances that it can engineer a soft landing. By the Fall, we will very likely have two negative quarters of GDP and the further economic deceleration discussed above. To the extent that inflation pressures are in fact on the cusp of easing, these factors will affect thinking at the Fed. The inflation situation may turn out to be transitory after all, just not as transitory as the Fed initially calculated. Stalling growth and easing price pressures should give the central bank the room to change its tune to one that is less hawkish. In fact, interest rate futures markets, which are aligned with the Fed’s forecasts of the federal funds rate for the rest of 2022, indicate that markets expect the Fed to begin easing by early next year.