Previously published on September 23, 2022 in
By Milton Ezrati, Chief Economist at Vested
Markets sank last week when the Federal Reserve (Fed) hiked its benchmark federal funds rate 75 basis points to a target of 3-3.25%. Having expected this move, the market’s response had less to do with what the Fed did than what it promised at the same time. Policy makers not only indicated future rate hikes, but their forecasts revealed how ready they are to risk recession in order to corral inflation.
Part of that message comes from the Fed’s forecasts. Its policy making Open Market Committee (FOMC) indicated an expectation that federal funds will stand just under 4.5% by year end. That is more than 100 basis points above the newly announced target. It is also indicative that this is just the latest jump in a year-end interest rate target that has risen from 0.9%, last December, when Fed Chairman Jerome Powell was still describing inflationary pressure as “transitory,” to 3.4% last June and so to this most recent 4.4%. It is not hard for investors to extrapolate this pattern and anticipate still higher targets in the next few months and into 2023. Investors certainly have encouragement in this from Powell’s clear indication that controlling inflation is now the Fed’s number one priority, almost regardless of any collateral damage that effort might cause.
History reinforces these interpretations of future Fed actions. For any who can remember the last great inflation of the 1970s and 1980s or have studied it, it is apparent that monetary policy can make no headway against inflation until interest rates rise to levels that rival the rate of inflation itself. Consider that today, even after pushing the federal funds rate above 3.0% and with 10-year treasury yields at almost 4.0%, inflation of over an 8% rate still allows borrowers to repay loans with dollars that have lost more real buying power than those borrowers pay in interest. This encouragement to use credit must end before monetary policy can put a crimp in inflation. This pressure on monetary policy is especially acute in 2022 because fiscal policy is doing nothing to slow the flow of federal monies into the economy. On the contrary, recent policy, such as the student debt forgiveness, has only accelerated that dollar flow.
If it is now clear that matters demand still higher interest rates and that the Fed seems committed to that need, investors increasingly are coming to terms with the likely economic ramifications – in other words, a heightened risk of recession. Rate increases have already made such a prospect clear by crimping housing sales and putting downward pressure on real estate prices. Even with a construction uptick in August, new housing starts stand nearly 13% lower than last April when the interest rate increases began. Actual new home sales have fallen almost 40% from their highs of last January, while the National Association of Realtors reports that the median sales price of an existing home declined 2.4% between June and July, the most recent month for which data are available. There is every reason to expect that still higher rates will redouble such effects in this important sector and have similarly adverse impacts in the economy generally.
The members of the FOMC have begun to recognize this prospect. Last December, they were forecasting 4% real growth for this economy. By June, they had reduced that expectation to 1.7%. They now expect only 0.2% growth in the nation’s real gross domestic product (GDP) for 2022 – statistically no different from zero. To some extent, this assessment by the members of the FOMC simply accounts for the outright declines in real GDP in the year’s first and second quarters. But the assessment also accounts for the ongoing economic effects of Fed policy. The fact that the forecast now is little different from recession territory speaks volumes.
The nation – and the Fed – could get lucky. The inflation might dissipate quicky on its own. Anything is possible. But it is highly unlikely. Two months of inflation relief in July and August, though the White House has seized on them, offer no such sign. They are entirely a reflection of a drop in gasoline prices. Core inflation – excluding food and fuel – actually accelerated in August. Without gasoline price declines, the consumer price index (CPI) in August would have registered about 9% above August 2021 levels. And gasoline price declines of the sort experienced in July and August are not likely to persist. Daily prices for gasoline have stabilized in September, suggesting that at best they will show no increase in the September CPI, still something or a relief, but hardly the sharp declines the index incorporated in July and August. Meanwhile the coming of winter does not bode well any lasting relief on fuel prices generally, especially with Russian natural gas off the European market.
This picture leaves a future with four key attributes: First, continued concerns over inflation will persist. Second, the Fed will continue to raise interest rates. Third, the Fed’s actions will continue to retard the pace of economic activity. Fourth, the financial/economic environment will continue to weigh on stock and bond prices.