Small Paddle, Big Rapids: What the Economy Could Do to the Fed
Published on March 21, 2022
David Kelly
Chief Global Strategist at J.P. Morgan Asset Management
Despite their best intentions, the Federal Reserve sometimes appears to be trying to steer a big boat, through violent rapids, armed only with a small paddle. The reality is that forces well beyond their control will mostly determine the fate of the economy. However, the energy with which they paddle could have a major impact on investments.
Last Wednesday, the Federal Reserve took a sharply hawkish tack, raising interest rates for the first time since 2018 and projecting a further six rate hikes in 2022. In covering this story, commentators worried first about whether this would be enough to tame inflation and second about whether it might be too much, pushing the economy into recession.
For investors, however, this is missing the point. The truth is that, at least in the 21st century, monetary policy appears ineffective at achieving economic goals but has profound impacts on capital markets. Easy money in the last expansion didn’t succeed in significantly boosting either inflation or growth and tightening over the next few years may do little to suppress them. It should be emphasized that both growth and inflation should slow for other reasons. However, if the expansion continues and inflation doesn’t abate quickly enough, the Fed may feel compelled to adopt a much tighter policy precisely because of the very muted impact of higher interest rates on the real economy.
This could be very important for capital markets. Years of low interest rates have boosted asset prices in general, favored growth stocks over value and funneled money into the most speculative parts of financial markets. A long period of higher interest rates, should it emerge, could reverse all of these trends. All of this depends on how resolute the Fed is in trying to bring inflation back down to its 2% goal and whether economic forces will permit this to happen. In other words, investors should ask not what the Fed could do to the economy but rather what the economy could do to the Fed.
In addressing this question, a good place to start is to consider how the economy might evolve even as the Fed raises rates. The story is, of course, complicated, encompassing the lagged impact of fiscal stimulus, continuing supply chain disruptions and the stark implications of very limited labor supply growth in an already very tight labor market.
On economic growth, it still seems likely that strong demand will cause the economy to grow above its potential in 2022.
Consumer spending should remain strong, reflecting solid income growth, strong balance sheets and pent-up demand. Low mortgage rates and only moderate credit growth over the past two years have cut debt service costs relative to income while wage and salary income has increased by roughly 11% over the past year. Auto sales, which averaged 17.2 million units in the five years before the pandemic, have averaged just 14.7 million over the past two due to chronic supply shortages, leaving a cumulative shortfall of 5 million units. There is similar pent-up demand across many consumer goods industries while fading pandemic effects should continue to support a strong rebound in travel, entertainment, leisure and food services.
Capital spending should also be strong in 2022 as companies take advantage of booming recent profits and still cheap financing to install labor-saving equipment. Home-building should also be relatively solid, even in the face of rising interest rates, as inventories of homes for sale are at record lows.
Despite very low stockpiles across the economy, rebuilding inventories could actually be a drag on growth, perversely, since real inventory accumulation is unlikely to match its huge fourth-quarter 2021 pace of $171 billion annualized.
Government spending may grow at a more modest pace as state and local governments struggle to compete with the private sector for a limited pool of workers and federal spending growth downshifts following the pandemic years.
In addition, international trade will likely be a drag on U.S. growth. Overseas growth is likely to restrained by the impacts of Russia’s invasion of Ukraine on Europe and continued Covid waves in East Asia while a recently higher dollar will also tend to widen the trade deficit.
However, since consumer spending and private fixed investment spending account for roughly 86% of GDP combined, strength in these areas should dominate, resulting in real GDP growth of 3.5% in the year ended in the fourth quarter of 2022 – well above the economy’s long-term growth potential of about 2% and the Fed’s projection of 2.8%.
Importantly, it is hard to see how even the seven interest rate hikes the Fed projects for 2022 will put a dent in this growth. The most interest sensitive sectors of the economy, home-building, capital spending and, to a lesser extent, auto sales, are all experiencing massive pent-up demand which is unlikely to be reduced significantly by modest increases in very low interest rates.
Similarly, the labor market is seeing dramatic excess demand with 5 million more job openings than unemployed workers. This, in combination with solid GDP growth, should lead to strong job gains in 2022 with the unemployment rate likely falling significantly from February’s 3.8% reading. Indeed, with much stronger wage gains and still limited labor supply due to demographic issues, the unemployment rate could easily fall a further 0.5% by the fourth quarter, cutting to its lowest level since 1953 and below the Fed’s current projections of 3.5%.
The core consumption deflator was up 5.2% year-over-year in January and, we estimate, may have been up 5.5% year-over-year in February. The Federal Reserve expects this to fall to 4.1% year-over-year by the fourth quarter and we estimate that it could fall a little further to roughly 3.8%. However, this would still leave it far above the Fed’s long-term 2% target by the end of 2022. Moreover, with still strong wage growth and higher inflation expectations, it seems quite possible that core inflation will still be above 2% by the end of 2023.
And this gets to the key question for investors. If the economy does not appear to be cooling down in the face of a now-projected seven rate hikes in 2022, will the Federal Reserve be more aggressive in raising rates in 2022 or exceed their now projected four rate hikes for 2023? Will they reduce their balance sheet more aggressively to try to raise long-term interest rates and elicit a greater response from the more interest sensitive sectors of the economy?
The Fed’s communications last Wednesday, both in their forecasts and in Chairman Powell’s comments after the meeting, suggested that they are now willing to take this more aggressive stance. If they maintain this attitude and become frustrated by their lack of progress in dampening inflation, we could be in for a period of significantly higher real interest rates. This would tend to be negative for fixed income markets, of course, but also for stocks trading at high multiples and more speculative areas of the market. It could be positive for value stocks and international stocks which trade at lower multiples and also could favor short-duration fixed income.
Eventually, fiscal drag from Washington, private sector efforts to attack supply-chain issues and the long-term forces which led to declining inflation in the four decades before the pandemic recession should erode inflation. However, if the Fed is sufficiently determined to battle inflation in the short-run and frustrated in its lack of short-term success, America may have reverted to an era of higher and more normal interest rates by the time the inflation tide finally begins to ebb.
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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.
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