Hawkish Fed will likely spark recession in late 2022

Insights for What’s Ahead

• As expected, the Fed hiked interest rates by 75 basis points today - the fourth consecutive increase this year and the second 75 basis point hike in a row. This move raises the Fed Funds range to 2.25 to 2.50 percent, which pushes the rate out of the “accommodative” range and into “neutral” territory (between two and three percent). 
   
• Chair Powell said that a 75 basis point hike is possible at the next FOMC meeting in September, but that it was by no means guaranteed. However, he stated that the FOMC expects that additional tightening will be needed to achieve price stability. Now that the Fed has pushed policy rates into “neutral “ territory, as it had said it would, it will make future rate decisions on more of a meeting-by-meeting basis.
   
• The Conference Board continues to expect the Federal Reserve to raise rates above three percent by the end of 2022 and that additional rate hikes will drive rates toward four percent in 2023. We believe that this will push the US economy into recession toward the end of 2022 (link).
   
• Taken together, the path of interest rates points to increased costs for capital for firms and the potential for reduced investment in capex, and IP. The rising recession risk also suggests businesses may reverse hiring plans, pulling job openings, but continuation of labor shortages in some industries likely should keep the national unemployment rate from rising materially.

What Were the Fed’s Actions?

The Fed continued to front-load rate increases. FOMC participants voted unanimously to raise interest rates 75 basis points, effective July 28, 2022. The move is the fourth consecutive increase this year and the second consecutive 75 basis point hike. Last month’s 75 basis point increase was the largest seen since 1994. Ultimately, Chair Powell said that policy rates are now firmly within “neutral” territory (between two and three percent) which had been its immediate goal.

The Fed will continue to reduce its balance sheet at the rate announced in May and implemented in June. The cadence of the reduction is currently at $47.5 billion per month ($30 billion in Treasury securities, and $17.5 billion in agency debt and mortgage-backed securities) but will rise to $95 billion per month ($60 billion in Treasury securities, and $35 billion in agency debt and mortgage-backed securities) in September. Chair Powell noted that it could take two to two-and-a-half years to get the balance sheet back to where the Fed wants it.

What is the Fed’s Assessment of the Current Economic Environment?

Some parts of the US economy are softening, but we are not in a recession (yet). The Fed’s policy statement immediately acknowledged that some economic indicators, like spending and production, have softened. However, it immediately went on to say that job gains have been robust and that the unemployment rate remains low. Chair Powell went on to say that he does not believe that the US economy is currently in a recession due to strength in the US labor market. However, he also said that Fed actions will likely produce a period of below trend economic growth and softening of the labor market. He noted that inflation could be lowered without inducing a future recession, but “that path is narrowing and may narrow further.”

The Fed remains highly attentive to inflation risks. The Fed policy statement also made it clear that inflation remains elevated and that price pressures are broad. It noted that supply and demand remain imbalanced as a function of the pandemic, energy and food prices. It also noted that Russia’s war against Ukraine is creating additional upward pressure on inflation and weighing on global economic activity. Chair Powell said that volatility in food and energy prices could impact headline inflation readings over the coming months and that the Fed will remain focused on core inflation readings. However, he also said that the headline inflation reading are important as well – especially because they have an impact on inflation expectations.  He said he does not believe higher inflation expectations are entrenched yet.

Forward guidance on Fed policy. Chair Powell noted during his press conference that the Fed has now achieved it’s immediate goal of raising policy rates into “neutral” territory, but that future decisions on monetary policy will need to be made on a meeting-by-meeting basis. As such, the amount of guidance that the Fed provides on future actions will likely diminish somewhat. The Fed will be focused on movements in economic data, including inflation, labor markets, and other indicators, as it formulates policy. However, Chair Powell said that the June Summary of Economic Projections was still probably the best gauge of the FOMC’s attitudes about future rate increases. The June SEP is consistent with out own Fed Funds forecast, which calls for rate to rise to 3.4 percent by the end of 2022 and to 3.9 percent by the end of 2023.