Tightening presents major risks for global and US growth
Fed rate hikes are likely to slow US growth by 2023. In an environment with narrowing growth opportunities, firms should consider streamlining product offerings toward demand-inelastic essentials, as well as seeking out clients downstream from these segments and clients in less cyclical sectors, such as utilities and healthcare.
As bond market stress rises, firms should carefully review the liability side of their balance sheets. Bond market volatility can cause sudden funding cost increases and refinancing problems. Careful hedging and capital structure management can mitigate this.
Fed tightening will contribute to further depreciation across most developed- and emerging-market currencies in the next quarter. Tightening monetary conditions also raise the specter of widespread sovereign debt crises. Firms should continue to monitor to macroeconomic and balance-of-payments outlooks for signs of instability in their key markets.
Overview
The persistence of the recent bout of high inflation caught central banks around the world off guard. The US Federal Reserve was especially behind the curve and in recent months made a dramatic shift to rate increases in an attempt to get a lid on inflation.
While the Fed has somewhat softened its stance in recent weeks, it is still on course to aggressively tighten. The federal funds rate will likely reach 3.25% by March 2023. This tightening will slow US growth, but also global growth, as companies and governments around the world depend on cheap dollars to fund investment, trade, and everyday spending. The Fed is in a bind. Hike too fast and growth is suffocated. Hike too slow and inflation gets out of control.
Our View
Tumbling stock prices and growing recession fears were enough to prompt Fed officials to walk back talks of harsh 0.75% hikes in May. After the 0.5% rise this month, we expect further 0.5% hikes in June and July, before the Fed likely switches to more moderate 0.25% rate rises for the rest of 2022.
Nonetheless, tight labor markets and strong spending in April might persuade the Fed it can safely escalate again, continuing 0.5% hikes beyond summer. This becomes likely if headline CPI inflation comes in above 8% again in June, caused by, for example, rising service inflation, Ukraine war dislocations, or Shanghai lockdowns.
However, this is not our base case. Measures of broad inflation have been falling since January. A rapid shift back to pre-pandemic demand patterns has seen two months of falling prices for durable goods. While China’s lockdowns will exacerbate inflation in goods, they will also ease energy and materials inflation by reducing demand. This makes further Fed escalation unlikely.
Even without further escalation, the strength of the Fed’s existing tightening plan is already being felt. Mortgage applications have plummeted. The rate-sensitive tech sector is announcing layoffs and hiring slowdowns. The cumulative effects of tighter credit will build through the year, and by mid-2023 a US slowdown is highly likely. The picture is worse globally, where growth is less buffered by strong consumption, but investment is nonetheless dependent on US rates. In recent weeks, gross emerging-market capital outflows were the highest since the panic of 2020, an early sign of trouble.
Despite these downsides, the US’s growth outlook looks strong enough to absorb rate increases in the short term. Construction backlogs and demographics will likely prevent home prices from falling. Strong demand will likely prevent net job losses in 2022, keeping the wheels on spending this year. One way or another, rate hikes will eventually slow growth. Yet, for the rest of 2022, US growth looks fairly resilient.
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