As of late June 2022, we learned that the Federal Reserve is “strongly committed” to reducing inflation. According to Fed Chairman Jerome Powell the U.S. economy is strong enough to handle the planned upcoming interest rate hikes. “The American economy is very strong and well-positioned to handle tighter monetary policy” Powell said at a recent Senate hearing. He also said that the pace of future interest rate changes will depend on the data and that the Fed will “continue to communicate our thinking as clearly as possible.”
The big question, of course, is: Will raising interest rates drive the economy into a recession? Given the large reduction in inflation that needs to occur, from over 8% down to 2%, this is not going to happen overnight and will require persistence. A soft landing appears very difficult. With that point made, a recession (defined as two quarters in a row of negative GDP growth) is likely in the cards. According to CME FedWatch, the market is expecting about two percentage points of additional rate hikes as the Fed struggles to contain and suppress inflation. Two percentage points! Wow. We haven’t seen anything like this in a long time.
One thing to keep in mind is the politics of a recession. Inflation is causing consumers angst. Have you been to the pumps recently? Inflation concerns have led to a significant fall in consumer sentiment, which fell to its lowest point in the last decade according to the University of Michigan’s May sentiment survey. Because rising prices in basics such as food, gas, and rent have an outsized impact on lower-income households, politics will likely come into focus with midterm elections in just 5 short months. A Wall Street Journal poll shows 44% of economists surveyed now expect a recession within the next 12 months. That number is nearly double the share in April and up from just 18% in January. A soft landing is becoming much harder to engineer. For example, some have suggested that if there is enough of a rise in unemployment to trigger a recession, that could cause the Fed to pause rate hikes.
But is this realistic? According to press reports, Treasury Secretary Larry Summers said that the U.S. would need five years of unemployment at 6% to contain inflation—or two years of joblessness at 7.5%, or one year of unemployment at 10%. The current unemployment rate is 3.6%. However, the Fed may be challenged to control inflation: they can only impact demand with higher rates. Nothing they do will resolve the conflict in Ukraine, increase oil production, or loosen Covid restrictions in China. Each of those are currently restricting supply and pushing prices higher. More likely, demand will need to be brought down in order to keep inflation lower – and the economy could have little to no growth for a while. Some economists predict stagflation before a recession takes place. At the most recent hearing, Powell estimated the longer-run neutral rate of Federal funds would be about 2.5%. He added that the Fed believed it would be appropriate to raise rates to a modestly restrictive level to curb inflation.
In short, we don’t know where the economy is heading – but a technically defined recession (two quarters in a row of negative GDP growth) is something investors may have to reckon with as the next 12 months unfold. In fact, we may already be in a recession. If the second quarter GDP comes in negative, this will meet the technical definition. As always, we recommend investors pay attention to their risk level and rebalance to targets. This is the way to achieve success in the long run.