Big Fed Rate Hike Risks Policy Error That Could Lead To Recession

As it worked to bring interest rates back toward neutral in the face of too-high inflation, before reassessing conditions, the U.S. Federal Reserve has been somewhat data-independent barring a “break the glass” moment. The Fed appears to have arrived at that moment.

The Fed slammed on the inflation brakes hard on June 15, raising rates 75 basis points (bps).

This action increases the risk of a policy error: if the Fed overtightens in trying to curb inflation, it could inadvertently slow the economy so much that it induces a recession rather than a “softish” landing.

Fed Chair Jerome Powell admitted as much the following week in testimony before the U.S. Senate Banking Committee. When asked if the Fed’s moves could lead to a recession, he replied, “It’s not our intended outcome at all, but it’s certainly a possibility.”

Inflation remains a big problem: 8.6% against the Fed’s 2% target is akin to doing 73 miles per hour (mph) in a 25-mph zone. The Fed has pumped progressively harder on the brakes since last fall, hoping to slow the U.S. economy while maintaining the current expansion. Then came the big 75 bps hike and the Fed’s signaling of a more aggressive tightening path in the second half of 2022.

Markets had priced in a second consecutive 50 bps rate hike the week before the Fed announced at 75. But two datapoints came out on June 10 that set in motion the switch upwards.

May’s Consumer Price Index (CPI) topped expectations, driven by higher energy prices. The University of Michigan Index of Consumer Sentiment preliminary June number missed badly, falling to its lowest level in history. Of survey respondents, 46% attributed their negative views to inflation. Gas prices were mentioned by half of all respondents during their interviews.

After remaining largely stable over the prior year, the survey’s long-term (5-10 years) inflation expectations jumped 0.3% – a substantial increase for such a long-dated measure. This suggests a potential unanchoring of inflation expectations.

The market has projected 3.25 additional rate hikes this year. That projection is endorsed by the Fed’s “dots,” indicating a much higher year-end policy rate.

If these hikes come to fruition, they will represent the second-largest cumulative rate increase in the 12 months following lift-off since the mid-1950s. Rapid, substantial tightening will eventually cool an economy already slowed in the wake of post-pandemic reopening normalization as well as higher energy prices.

Monetary policy, unfortunately, is ill suited to handle supply shocks such as higher energy prices resulting from geopolitical conflict. While the Fed can continue to hike aggressively if geopolitics cause energy prices to remain high – or rise further – headline inflation and inflation expectations may not improve very much. Although monetary policy acts with a lag, and slower inflation is a reasonable expectation from rate hikes, the impact of hiking could be smaller now.

It is plausible that more substantial tightening is still to come before the Fed backs off.

Yet economic conditions remain strong, a sentiment echoed by Powell at the Federal Open Market Committee press conference, where he said he did not see signs of a broader slowdown.

Given the health of household balance sheets, it could take time, but ultimately, the lagged effects of tighter monetary policy will threaten to overwhelm the consumer – the driver of two-thirds of the U.S. economy. Early signs are appearing with cooling activity in the housing market and hiring freezes/layoffs, primarily in the technology sector.

A recession is not a certainty. The Fed can pivot again, and other positive developments may emerge. The evolution of the economy likely will prove to be anything but a straight line.

In this year of transition, long-term investors should remain patient, and alert to opportunity. What has changed is the magnitude of what might transpire, not the direction of the economy.

Jeffrey Schulze, CFA

CFA
, is a director and investment strategist at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice.

Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.

Past performance is no guarantee of future returns. Performance source: Internal. Benchmark source: Standard & Poor’s.

Franklin Distributors, LLC (“FD, LLC”), Member FINRA, SIPC. FD, LLC and Clearbridge Investments LLC are Franklin Templeton affiliated companies.

CFA® and Chartered Financial Analyst® are registered trademarks of CFA Institute.

###