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Better to Have Loved and Lost... Rate Hikes and the Economy

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Wall Street’s love affair with low rates and the Federal Reserve is about to come to an abrupt end. Fed Chairman Jay Powell all but promised to start raising rates in March following the January Federal Open Market Committee (FOMC) meeting. He said that “…it will soon be appropriate to raise the target range for the federal funds rate.”

He warned that a drawdown in the Fed’s $9 trillion balance sheet could soon follow. He said that the balance sheet reductions would be more “orderly and predictable” and in the “background.” The Fed would like short-term rate hikes to be the primary tool against inflation. Reductions in the balance sheet, officials hope, will be less noticeable and akin to watching paint dry.

The Fed is now expected to raise the target on the fed funds rate five times by 1.25% in 2022, starting in March. It could announce plans to reduce its balance sheet as soon as June. The Fed would prefer to hold Treasury bonds over mortgage-backed securities, which is one reason that mortgage rates have moved up even faster than Treasury yields in recent weeks.

At least one of the hikes this year could be one half instead of one quarter percent. Why the urgency?

  • The inflation we are enduring is global in scope;
  • has far exceeded the expectations of central bankers at home and abroad; and
  • risks becoming entrenched and baked into wage gains, much like we saw in the 1970s when stagflation occurred.

 
Fed Hits Brakes On Growth
Real GDP is expected to slow to a 1.5% pace in the first quarter, almost one fifth of the 6.9% pace we saw in the fourth quarter of 2021. Disruptions triggered by the Omicron wave are the primary reason for the weakness. Spending on goods held up better than spending on services. Reservations and walk-ins at restaurants plummeted. Throughput at TSA checkpoints dropped. Hotel occupancies fell. Movie theaters emptied. Home buying and building treaded water as shortages and weather delays mounted. Inventories likely drained; the trade deficit is expected to hold steady. The outlier is business investment, which had a tailwind entering the year.

Real GDP is forecast to rebound at a 3.2% pace in the second quarter. Bookings for spring break have picked up; some popular vacation spots are already sold out. Home buying and building is expected to begin to feel the bite of higher interest rates along with business investment. Inventories are expected to rebuild, while the trade deficit is expected to improve. Gains in state and local government spending should offset a drage in federal spending.

Growth for all of 2022 is forecast to average 3.3%. That marks a sharp slowdown from the 5.7% pace we saw in 2021, but is still strong. Unemployment is forecast to dip to 3.2% by year-end, the lowest since the early 1950s. Participation in the labor market is expected to remain lower than it has been in decades in 2022.

The Fed can’t risk that; it has already suffered a blow to its credibility by letting inflation persist this long.

Pandemics usually boost wages but not inflation. This time was different. The hope was that the loss of life would be contained by leveraging the science that our forefathers lacked. We failed; excess deaths are now on par with previous pandemics. The Delta variant was particularly hard on younger workers.

This is at the same time that technology and unprecedented fiscal and monetary stimuli helped blunt the blow to demand. Larger swaths of the global economy pivoted to working from home and retained their paychecks, even as fear of contagion spread.

Those who could bought everything possible to ease the monotony of quarantines. Purchases of homes, furniture, RVs, boats, vehicles, electronics, furniture, appliances and exercise equipment skyrocketed. Shortages erupted and prices flared.

This edition of Economic Currents takes a closer look at how the economy is likely to weather rate hikes by sector. This is the first time the Fed has had to chase inflation since the 1980s; it will be painful.

Chart 1

Real GDP growth stalls in 2023

We are assuming that the pandemic morphs into an endemic with outbreaks that are worse than the seasonal flu. We have the tools to make conditions better, but have yet to fully leverage them. Hope that resistance to vaccines and masking will dissipate seems fanciful.

Headwinds Mount The 2022-23 Outlook Chart 1 shows the forecast for growth in 2022 and 2023. The economy is expected to rebound after an Omicron-induced slowdown in the first quarter. Growth is poised to slow as fiscal and monetary stimuli come to an end. Outbreaks are expected in the summer and winter, but are not likely to be as disruptive.

The prospects for 2023 are worse. The economy slows to below its potential and comes close to stalling out. The unemployment rate moves up slightly but we avoid a full-blown recession; it’s a close call.

Chart 2 shows the trajectory for inflation. The core personal consumption expenditures (PCE) index is poised to cool but remain well above the Fed’s 2% target into 2023. That will extend the Fed tightening into next year.

Chart 2

Inflation cools too slowly for the fed

Supply chain problems are expected to ease up in the second half of the year, although the shortage we are seeing in computer chips could take longer. Much depends on the persistence of demand and how well we can contain future outbreaks.

Inflation in the service sector, where labor is a larger component of costs, is expected to be pernicious. Shelter and medical inflation are likely to overshadow goods inflation in the year to come.

The goal of the Fed is to lower the pace at which prices rise, not the level of overall prices. That adds to the political backlash we are seeing to inflation. Consumers would like to see prices recede, not just slow.

Financial markets are more interconnected than they were in the past, which should shorten lags between rate hikes and a slowdown in economic conditions. The problem is labor market conditions, which are much tighter than they were. In December, we had 1.7 job openings for every worker actively seeking work; we’ve never seen anything like this before.

The resilience of employment through the worst of the Omicron wave in January only affirmed the Fed’s resolve to move sooner and more aggressively than in the past. Acute labor shortages leading into the current wave and a record-breaking number of workers out sick due to COVID have prompted many employers to hold onto more holiday hires than they did in the past.

Consumer Spending Moderates Spending on big-ticket durable goods, which span everything from vehicles to furniture and appliances, is more sensitive to interest rate hikes than spending on services. That is because big-ticket purchases are more likely to be financed.

Backlogs will carry sales for a little longer than one might expect under normal circumstances. (Not that we even know what normal is anymore.)

That resilience is actually a double-edged sword for producers as it could signal that demand will be more resilient than it actually is. We can’t rule out an unwanted surge in inventories as we move into 2023, assuming supply chain bottlenecks are resolved.

Conversely, consumers have exhausted spending on many of the things that made quarantines more tolerable. We have already seen the impact of that on companies like Peloton, which was forced to cut production as demand faltered in early 2022.

The pent-up demand for services differs from that for goods. You can’t recoup haircuts and vacations lost to the pandemic. Instead, you might splurge on a more extravagant vacation.

Get in line and prepare to pay up, as much of the industry that once serviced travel and tourism will not make it to the other side of the pandemic. Businesses are now cutting travel and their offices to reduce costs and their carbon footprints. Clients and investors are requiring businesses to meet more aggressive Environmental Social and Governance (ESG) targets. This will further stress the convention business and supporting services in urban centers.

Home Buying and Building Will Wane Real estate is among the most interest rate sensitive of industries. Purchase applications for mortgages have already fallen from the peak we saw in late 2021, as buyers scrambled to lock in the last of low rates.

Long backlogs, acute shortages and the emergence of all-cash investors, who are buying to rent instead of sell, are expected to dampen the initial blow of higher rates. The lags on multifamily construction are longer than those for single-family home builders. Low vacancy rates and rising rents could make investments in multifamily projects more attractive than single-family.

We can’t rule out a more abrupt slowdown in the housing market. First-time buyers have already been squeezed out of most markets, while mortgage financiers are easing lending standards to make up for the fees they are already losing. Cash-out refinancing activity has picked up; this is one of many things that got the housing market in trouble during the subprime crisis.

The good news is that mortgages have a much larger cushion of equity in place than they did during the global financial crisis. (It would be hard to have less; too many properties were sold with zero down payments during the bubble of the early 2000s.)

Business Investment Slows Investment in new equipment, intellectual property, computers and components is expected to slow after a spurt at the start of the year. The question is what happens to productivity growth. We saw a surge in productivity with the pivot to working from home.

We could see those gains linger as the technology we have becomes more evenly distributed across the economy. Even family-owned restaurants were able to pivot to online ordering and deliveries almost overnight.

However, productivity growth is bounded; wages are not. They can rise much faster than many businesses can absorb the shock of higher labor costs, especially in the labor-intensive service sector. The use of robots to serve food at the Beijing Olympics is a hard model to replicate without massive subsidies by the government. It is also unclear that it is preferable.

Large, tech-savvy firms are better at leveraging technology and substituting capital for labor than small and mid-sized firms. That is one reason that the largest firms are currently setting the floor for wages. The pandemic has accelerated the concentration of employment at large firms. This is despite a surge in new business formations, notably in technology.

The business models of small and mid-size firms are being challenged; more will fail. Many small restaurants lack the staffing to even answer the phones.

Investment in commercial real estate, which has already been hammered due to the pivot to working from home, is expected to contract. Plans for lodging, resorts and retail construction remained weak at the end of 2021. The pipeline on manufacturing and warehousing held up better. Those gains are expected to reverse as inventories become bloated in 2023.

Inventories Balloon Inventories, which were drained to rock bottom levels as spending on goods soared, are rising again. Producers are pushing hard to catch up on backlogs and restock dealer lots and store shelves.

The move from just-in-time to just-in-case inventory systems, and the double ordering that occurs as producers scramble to hedge against shortages, set the stage for an overshoot. The result is a boom/bust inventory cycle, which we haven’t seen in decades. Those shifts will trigger discounts and squeeze profit margins, but not until well into 2023.

State & Local Gains Blunt Cuts to Federal Spending Government spending slowed in 2021 as the emergency aid and stimulus abated. A good portion of what was allocated went unspent. Federal spending is poised to slow further in 2022 as Congress has yet to agree on a budget for the 2022 fiscal year, which started last October. This is at the same time that the administration’s Build Back Better plan appears to be dead in the water.

A bipartisan infrastructure bill did get passed last year, but those projects take time to ramp up. We are not expecting to see any major boost from infrastructure spending until we get into 2023 and 2024.

The prospects for spending by state and local governments are better. Sales and real estate tax revenues surged as spending on goods and homes soared. Add the cost savings associated with the pivot to online from in-person schooling, transfers in the last round of federal stimulus and state and local coffers are now flush.

States have been slow to spend those windfalls. Clarification on how transfers can be spent by the Treasury Department should open the door to more spending in 2022 and 2023. We are expecting the rise in spending at the state and local levels to offset but not fuel an increase in overall government spending in 2022.

Trade Deficit Treads Water A stronger dollar, and the slowdowns triggered by tighter fiscal and monetary policy, will put a damper on both imports and exports. The result is very little movement in the trade deficit over the next two years.

The wild card is China. A collapse in real estate, high debt loads and its “zero tolerance” policy on outbreaks mean it will no longer be the engine of global growth. Exports could come in even weaker than forecast.

Risks: Growth could come in much weaker than forecast in 2022; the economy could slip into a recession in 2023. The Fed will be quick to retrace its steps once inflation is under control — but may not realize it until the economy has stumbled. Inflation could become more persistent and require more aggressive moves than the Fed anticipates to bring it down.

Bond Yields Jump The yield on the 10-year Treasury bond is expected to rise from 1.5% at the end of 2021 to 2.9% at the end of 2022. That is the fastest move up in bond yields since the taper tantrum in 2013, which played out over the course of two years.

We have to go back to the Russian debt debacle and the bond rout triggered by the failure of Long Term Capital Management in 1998 to get to anything close to what we are forecasting for 2022. Before that was the surprise spike in rates by the Greenspan Fed in 1994/95.

Equity Markets Falter Stock valuations are expected to come down as rates rise. The models suggest a double-digit decline in 2022 is possible; that is without slipping into an actual recession. Forecasting the overall economy has proven humbling enough in the wake of the pandemic; I will leave the reading of the tea leaves for the financial markets to investment analysts.

Suffice it to say, financial markets are not likely to be feeling a lot of love for the Fed in 2022. Volatility has already surged. There was a time in my life when I liked roller coasters; now I prefer carousels.

Developing economies have already raised rates to defend their currencies and stem inflation in anticipation of rate hikes by the Federal Reserve. More rapid rate hikes and reductions in the Fed’s balance sheet could prove even more destabilizing and increase the risk of default. The Fed is well aware of the risks; that is one of many reasons that it would like to rely on rate hikes rather than reductions in its balance sheet to curb inflation. (That may be easier said than done.)

I know I am repeating myself but it is for a reason. There is no Las Vegas in the global economy. What happens abroad will likely show up on our shores as well. This is when the water metaphorically recedes and we get to see who isn’t wearing a bathing suit.

Bottom Line Inflation is likely to get worse before it gets better. Goods prices should abate as supply chain bottlenecks ease. Service sector inflation will likely prove more persistent.

The Federal Reserve has accepted that reality and is ready to force down inflation with higher rates. The challenge is knowing when to stop. The Fed has no history of achieving a soft landing when it was combating a surge in inflation. A recession may be inevitable.

Financial markets are particularly vulnerable to a correction as they attempt to wean themselves from ultra-low rates. Heartbreak is unavoidable as their love affair with the Fed comes to an end. Breaking up is hard to do.

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