A More Hawkish Fed May Trigger a Recession

Analysis?by?Erik Lundh, Principal Economist

Insights for What’s Ahead

• The Fed hiked interest rates by 75 basis points today and indicated that the Fed Funds rate would enter restrictive territory by the end of 2022. This may trigger a recession, in our view.
• Both the policy statement and Chair Powell were much more hawkish in tone given recent inflation data. The path to 2 percent inflation (the Fed’s target) is getting harder to achieve, not easier.
• Businesses should expect interest rates to rise much faster and higher than previously forecasted. The Fed funds rate may levitate to 3.25 percent by year-end and to about 3.75 percent by the end of next year.
• Meanwhile, retail sales (released this morning) declined in May. Monthly sales fell 0.3 percent from April, but when adjusted for inflation declined by 1.2 percent. However, these data may not be capturing a pickup in spending on in-person services.

What Were the Fed’s Actions?

The Fed is raising rates even more aggressively than previously anticipated. FOMC participants materially raised inflation projections and the number of interest rate hikes in 2022 and 2023. Chair Powell indicated that the FOMC currently foresees the Fed Funds rate rising to 3.0 to 3.5 percent by the end of 2022, and 3.5 to 4.0 percent by the end of 2023. These rates are well above the “neutral” rate range of 2.0 to 3.0 percent and are well into “restrictive territory.” Furthermore, Chair Powell indicated that the rate hikes will be front-loaded and that the July meeting would likely see another rate hike of 50 to 75 basis points. However, the Fed did not accelerate its plans on balance sheet reduction. Quantitative tightening, launched on June 1st, will continue as planned.?

What does this mean for the US economy? ?

The Federal Reserve’s Summary of Economic Projections (SEP) anticipates slower real GDP growth over the forecast horizon (Figure 1), but no recession. The FOMC projects Q4-to-Q4 2022 GDP growth of 1.7 percent and Q4/Q4 2023 GDP growth of 1.7 percent. These are significant downgrades from the growth expectations that were released in March. The FOMC also raised its expectations for inflation. The FOMC projects Q4/Q4 2022 PCE inflation of 5.2 percent now compared to 4.3 percent at the March meeting. For Q4/Q4 2023, it forecasts 2.6 percent.

These expectations are too optimistic, in our view. While our current outlook for economic growth in the United States is currently above the SEP’s, today’s developments will significantly change our forecast (expect an update to our forecast over the coming days). In our view, there are two potential paths forward:

1. The US will enter a recession later this year or early next. The substantial increase in interest rates described by Chair Powell will meaningfully curb consumer spending and business investment over the next 12 to 18 months. While this should help curb inflation, it will also likely result in a contraction in growth and a weaker labor market. Periods of stagflation, both before and after a recession are a real possibility.?
2. A lower growth environment. It is possible that the Fed may not need to go as far into restrictive monetary policy territory as indicated today. Bold, front-loaded rate hikes may be enough to temper demand and lower inflation expectations among US consumer. However, this “shock and awe” approach will not impact the supply-side driver of inflation. Periods of stagflation are likely in this scenario as well.

Clearly, the Fed’s priorities have evolved from what they were in 2021. A year ago, the Fed’s priorities ranked employment, growth and then inflation. Today the priorities are inflation, employment, and then GDP. Looking ahead, a slower growth environment appears certain and a recession appears likely.

May Retail Sales Growth Declined

May retail sales growth fell 0.3 percent from April as consumers pulled back on spending on some big ticket items. Spending on motor vehicles and parts dropped 3.5 percent from the previous month, and spending on electronics and appliances dropped 1.3 percent. Meanwhile, sales at gasoline stations rose 4.0 percent - in large part due to higher prices at the pump. Excluding spending on vehicles and gasoline, overall retail growth rose 0.1 percent for the month. The data, which are published in nominal terms, are even weaker when adjusted for inflation. When factoring in the latest CPI reading, real retail sales data fell by 1.2 percent in May.

While these data are clearly weaker, they may not be fully capturing strength in the services sector. Retail sales data are more focused on goods, as opposed to services. While food services and drinking places are included in retail sales data (and were up 0.7 percent month-over-month), spending on things like nail salons or hotel bookings are not. Thus, as US consumers pivot back to spending on in-person services as COVID-19 becomes less of a threat, the true trend in consumer spending may be a bit healthier than seen in these retail sales data. Fortunately, Personal Consumption Expenditures data offer a broader view of consumer spending dynamics and will be released later this month.?

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