Inflation Getting Worse Before it Gets Better; Interest Rate Hikes Could Be in Play by End of the Week
Amid soaring interest rates and a booming job market, the Federal Reserve raised interest rates this past week for the first time in four years. While the Fed’s stated long-term goal is to balance maximum employment with keeping long-term inflation rates in the 2% range, it’s clear they likely waited too long to make this move. Inflation had been ramping up long before the Ukraine crisis and its impact on energy prices, which is already driving even greater pressure on prices. The increase (from 0.25% to 0.50%) will likely be the first of seven incremental hikes this year (according to Fed Chairman Jerome Powell) that will likely see a 2.00% federal funds rate by the end of the year (assuming conditions don’t force a change in their stated policy).
There is a reason why economics is called “the dismal science,” and that is because the job of the economist is to evaluate risk. That said, the interpretation of this news ranges from the bleak (Rate Hike Starts Countdown to Next Recession), to skeptical (The Fed Expects a Soft Landing. Don’t Count On It). I completely understand the dilemma that economists face in an environment where risk has increased substantially. It is far easier to see the risks ahead than the countermeasures or the response to those risks that could potentially alleviate (or worsen) those trends. For example, most of us on the analysis side anticipated at the beginning of the pandemic that if it were an ordeal of at least 18 months, that one-third of all restaurants would fail. But while the sector was a focal point of damage, the data suggests that just under 20% of all restaurants closed during the pandemic. This wasn’t because economists were wrong on the risks that were apparent early in the crisis, it’s that PPP loans (though ham-handed, especially earlier in the pandemic), operator grit (concepts pivoting and adapting at lightning speed), and, most of all, landlord largesse prevented the damage from being far worse.
That said, we have been in a prolonged period of historically low-interest rates. Since 1955, the average Fed funds rate has been 4.63%. In fact, from 1955 through 2000, the average was 6.09%. If you just look at 2000 onward, that number falls to 1.63%. Since 2010 it’s averaged just 0.54%. The last ten years have been a historic anomaly, not the norm.
But this doesn’t mean a shift towards a higher interest rate environment, though a move towards more normal (historically) interest rates won’t be without a disruptive impact.
The metric that is creating the most gloom for economists currently is the yield curve. This is the relationship between the short- and long-term interest rates of fixed-income securities issued by the U.S. Treasury. An inverted yield curve occurs when short-term rates exceed long-term rates. Under normal circumstances, the yield curve is not inverted since debt with longer maturities typically carries higher interest rates than nearer-term ones. The challenge is that when the yield curve becomes inverted, it means that the near-term has become riskier to investors than the long-term. Thus, an inverted Treasury yield is one of the most reliable indicators of an impending recession.
Right now, the Fed is trying to thread a needle between taming inflation but not crashing the economy to do so. But, as David Barbuscia of Reuters points out in his article, U.S. Yield Curve Points to Recession Risk as Market Challenges Fed’s ‘Soft Landing,’ the yield gap between 10-year and two-year Treasuries has already narrowed by 60 basis points since the beginning of the year, with the longer-term notes now yielding just 21 basis points more than the two-year debt. An inversion of the two is generally seen as predating a recession by anywhere from seven to 24 months. This has been the case in all but one recession since 1955. Recent stock market volatility (major indices are down anywhere between 8% and 15% so far this year) as well as a market overreaction to interest rate hikes could easily result in an inverted yield curve in the next few months.
That isn’t necessarily how things will play out. When the Fed raised interest rates on March 16th; the Nasdaq initially fell to 13,049.29. By the end of the day, it rallied and as of the morning of March 21st stood at 13,893.84. The Dow Jones followed a similar pattern. The NYSE Composite Index didn’t even dip—it just climbed on the news as investors viewed it as a positive movement to head off inflation.
The risk of recession ahead has clearly increased with the impact of Russia’s invasion of Ukraine, though it’s far from a done deal. For one thing, uncertainty is likely to drive far greater foreign investment to safer harbors given current circumstances. Russia aside (which I would argue is already in the early stages of a deep recession), there is a very strong likelihood of a European recession. Meanwhile, investors are likely to also view China with far more caution. This means that the Americas are likely to be the beneficiary of investors seeking relative stability. A high level of foreign demand in U.S. securities could stem this tide. As could a significant ramp-up of oil production in the US and abroad. The increase in interest rates is also likely to start to cool the labor market in the months ahead, which will eventually slow wage inflation. The point is that the risk of recession has increased substantially, but it is not a given depending on a myriad of factors, not least among them the countermeasures we take.
That said, watch the yield curve closely in the weeks ahead. In 11 of the past 12 recessions, an inverted yield curve preceded a recession (both major and minor ones) by seven to 24 months.
See you next week,
Garrick
