Getting Going on Monetary Tightening

14 Mar

David Kelly

Chief Global Strategist at J.P. Morgan Asset Management

At 5:30AM on Saturday morning, Coach Jack posted on the team Facebook page – the training run was a go. Just as well.

The Boston Marathon is now five weeks away and as a proud member of the gasping geezers division of the Dana-Farber Marathon Challenge team, I knew we needed to get in a long run. Between Covid and the weather, training has not exactly been easy. On Saturday, the forecast was for rain with the possibility of torrential downpours. But getting wet on Saturday was a better choice than waiting any longer for ideal training conditions. Sometimes, despite adverse conditions and uncertainty, you just have to get going.

On Wednesday, the Federal Reserve will likely make the same choice, raising the federal funds rate by 0.25%, in a first rate hike since 2018.

The Fed’s decision will be guided by twin assessments, first, that the economy is strong enough to withstand the higher commodity prices and greater uncertainty emanating from Putin’s brutal invasion of Ukraine and second, that they cannot afford to wait any longer in taking some action to counteract the highest U.S. inflation in 40 years.

In their communications, they will likely emphasize that monetary tightening is not on a pre-set course. However, for investors, the critical issue is to assess the Fed’s determination to proceed along a path of monetary normalization and the potential for events in Ukraine, China and elsewhere in Washington to divert them from that path.

The decision to tighten will be based first on their view of the economy which will be displayed in their summary of economy projections.

When they last produced their forecasts, in December 2021, they expected that, by the fourth quarter of this year, real GDP would be up 4.0% year-over-year, the unemployment rate would average 3.5% and the PCE deflator would be up 2.6% year-over-year.

On growth, they may want to cut their numbers a touch. On the positive side, the pandemic continues to wind down and consumer services spending should show strong gains, particularly in the second quarter. However, higher energy costs and lower consumer confidence could act as a drag on consumer spending while uncertainty concerning the impact of Ukraine on the global economy could soften an expected liftoff in capital spending. However, even with this, fourth-quarter real GDP growth of between 3% and 4% still seems possible.

On the labor market, a fourth-quarter unemployment rate of 3.5% or below still looks likely. The recent JOLTS report showed a record 5 million gap between the number of job openings at the end of January and the number of unemployed workers in the second week in February. Even if uncertainty related to Ukraine cools the demand for workers somewhat, the labor market is likely to remain very strong by historical standards. This should make it easier for even the least qualified workers to find positions while a growing gap between wage rates and unemployment benefits will give potential workers a greater reason to hunt down available jobs. With the unemployment rate already down to 3.8%, Fed officials might even mark down their forecasts for the fourth quarter to 3.4% or lower. In this context it is worth noting that there hasn’t been a single month since October 1953 when the U.S. unemployment rate has been below 3.4%.

However, the most important adjustment the Fed is likely to make will be to boost their estimate of year-over-year inflation. Specifically, energy prices now look likely to be higher by the end of the year than previously thought even if they recede from today’s very elevated levels. In addition, further supply chain disruptions from the war in Ukraine or a broader Covid outbreak in China could add to inflation throughout the year. While inflation is still likely close to its peak, it is a higher peak than the Fed likely expected back in December and the PCE deflator could still be well above 3% by the end of 2022.

The economic outlook supports the Fed’s current plans to boost the federal funds rate in March and to begin to reduce their balance sheet over the summer. However, there are a number of areas of uncertainty which should make them a little more cautious in tightening.

The biggest question mark surrounds the implications of Russia’s invasion of Ukraine and the subsequent Western sanctions on Russia. As markets have adjusted to sanctions and possible Russian retaliation, global commodity prices have risen sharply with West Texas Intermediate Crude Oil climbing from $93.10 per barrel a month ago to an inter-day peak of almost $130 last Tuesday before falling back to $109.33 by last Friday.

This has been part of a broader increase in commodity prices encompassing energy, food and metals and should add meaningfully to global inflation this year. However, importantly, Western Europe has still not pledged to stop imports of Russian oil and gas nor has Russia halted exports to Europe. If this remains the status quo and higher prices gradually induce increased supplies from the U.S. and OPEC, oil prices could drift down from here, as is suggested by futures markets. However, a global response to further atrocities committed by Russia in Ukraine could yet result in a further spike in commodity prices, prolonging the inflation surge in the United States.

Another issue which could impact the outlook are signs that China is losing its battle to avoid a major Coronavirus outbreak. Hong Kong has seen a huge surge in infections with almost 700,000 confirmed cases and thousands of fatalities since late December. Mainland China has avoided severe outbreaks since the original Wuhan outbreak in late 2019. However, according to the Chinese CDC the daily case count on Sunday jumped to almost 3,400, more than 4 times the number from a week earlier with outbreaks reported in 23 of 31 national administrative districts. This suggests that China could be on the verge of a major wave. This would have tragic human consequences. However, it could also have global economic implications with potential shutdowns across manufacturing facilities and ports either because of widespread illness or attempts to suppress it.

Finally, the Fed will have an eye on the other side of Washington.

Last week, Congress passed an omnibus spending bill to fund the Federal Government through September. This, combined with last December’s $2.5 trillion increase in the debt ceiling, eliminates the risk of a politically-induced fiscal crisis in the current fiscal year. However, the bill may also effectively shelve for now any prospect of a restoration of enhancements to the child tax credit or other Democratic spending priorities as well as taxes to pay for them. While some tax and spending package could still be passed before the mid-term elections, it currently looks likely to be small and mostly paid for and thus should have little impact on the broad economic and investment environment.

It is also hard to see any major fiscal stimulus coming from the next Congress. In the last 25 midterm elections, the President’s party has lost House seats 22 times and Senate seats 19 times. With a slim majority in the House and a tied Senate, the odds strongly favor Republicans taking control of at least one house of Congress in November and blocking any further fiscal stimulus ahead of the 2024 presidential election.

Moreover, in the absence of further major legislation, the federal deficit appears set to fall sharply from over $2.7 trillion or 12.4% of GDP in fiscal 2021 to roughly $1.0 trillion or 4.1% of GDP in the current fiscal year. This is good news for those worried about spiraling federal debt precipitating a fiscal crisis. However, it also implies significant fiscal drag, giving the Federal Reserve a further reason to be cautious in their tightening.

In short, even with the Russian invasion of Ukraine and other issues, the Federal Reserve is likely to proceed with its plan to increase interest rates in 2022. As they do this, investors may want to shorten durations in fixed income and overweight value relative to growth within equities. Later on, if the situation in Ukraine stabilizes, the U.S. dollar could retreat from current high levels and much cheaper international equities could outperform their domestic counterparts.

However, it should be emphasized that the Fed will be particularly cautious in tightening because of heightened uncertainty. Investors would do well to follow their lead, maintaining very broadly diversified positions in what Chairman Powell has aptly described as “an extraordinarily challenging and uncertain moment.”

Disclaimer

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

Content is intended for institutional/wholesale/professional clients and qualified investors only (not for retail investors) as defined by local laws and regulations. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide (collectively “JPM”).

Opinions and comments may not reflect those of J.P. Morgan or its affiliates. Content is intended for US audience only, and should not be considered a recommendation or endorsement by JPM for any product, service or strategy specific to any individual investor’s needs. JPM is not responsible for third-party posted content. "Likes", "Favorites", shares, similar functionality or content appearing on third party websites should not be considered an endorsement of JPM products or services.

Report this