A Narrow Runway for a Soft Landing
As any pilot will tell you, take-offs are easy. It is landings that are the challenge. This is particularly true when flying a jumbo jet in a storm, with unpredictable high-winds and cross currents. Add in loud and unruly passengers along with a narrow runway, and a smooth touchdown is more than a bit uncertain for even the best pilots.
Since the mid-1950s, the Federal Reserve has raised short-term interest rates on fifteen separate occasions. In eleven of those cycles, the economy tipped into recession, which translates into 73% of the time. That figure, alone, should give investors and ordinary citizens pause as the Fed embarks on its sixteenth postwar tightening episode.
In his press conference last week, Fed Chairman Powell tried to put a brave face on matters. He noted that a strong labor market and high levels of household savings make the US economy more resilient to tighter monetary policy. While job losses may become necessary, Americans spared unemployment in this cycle may not be as unnerved as in previous downturns, or so the Fed’s thinking goes.
But after having wrongly forecast inflation as ‘transitory’ for much of 2021, the Federal Reserve’s already spotty forecasting record has become even less reassuring. To slow inflation the Fed will need to see a reduction in aggregate demand relative to aggregate supply. But for reasons we outline below, improvements in aggregate supply are likely to be small and late in arriving, implying that weak demand will bear the brunt of the adjustment.
Last week the Fed initiated its first half point rate hike in over 20 years. Chairman Powell also noted that the Fed will probably hike rates by 50 basis points at each of its next three meetings. Based on the Fed’s own forecasts, additional interest rate hikes will follow, bringing the Federal Funds rate to 3.0% by year-end 2033 and to 3.5% by mid-2023. If so, this would mark the most aggressive Fed tightening cycle since 1994–95.
In response, the repricing of assets has been brutal. Bond markets have dropped roughly 10% year-to-date, their worst start to a year since 1994. The US dollar has surged 10–15% against the yen, the euro, and other major currencies. It has also gained roughly 5% against the Chinese renminbi. Equity markets have soured, with major indices down 10–15% this year and some sectors, such as information technology, off even more.
Rising bond yields have depressed equity valuations, particularly for long-duration ‘growth’ stocks, including many in the tech sector. But it is wrong to ascribe equity setbacks solely rising yields. Wobbly equity prices also reflect deteriorating sentiment about earnings growth and rising uncertainty.
Fed tightening poses considerable risk to economic activity, and hence to corporate profits. Every economic recession in the postwar era has been accompanied by an earnings recession. Weaker growth is sometimes sufficient to push profits growth into negative territory. Moreover, aggressive Fed tightening today arrives as profits growth is already slowing, and as a rising US dollar makes exports more challenged. S&P500 earnings only grew half as fast in the first quarter of this year as they did in the second half of 2021. An earnings recession in 2022 is no longer out of the question.
Global equities have also been buffeted by other shocks. China’s steadfast commitment to ‘zero Covid’ means the continuation of economically damaging lockdowns and global supply chain disruptions. Russia’s invasion of Ukraine shows no signs of ending. Sanctions and war-related disruptions have pushed up global energy, industrial metals, and food prices, which will depress purchasing power and demand worldwide.
Accordingly, some part of the de-rating of global equity markets this year is also due to a rise in the (unobserved) equity risk premium, as investors demand higher future returns to hold riskier stocks in their portfolios.
As noted, Chairman Powell has expressed a sanguine outlook for the US economy. He has underscored that the unemployment rate is near 50-year lows and that the number of job openings is nearly twice as large as the number of unemployed. Powell conveyed a view that while higher interest rates would slow demand, scope exists for supply adjustments to ease the transition from high to lower inflation without a recession.
Unfortunately, China’s zero Covid policy, if left in place, undermines that case. China is the world’s largest exporter and last year China’s exports surged 30% in response to surging global demand. China’s ability to provide such “plug the hole” supply flexibility today is far less certain.
Moreover, the April US employment report contained unsettling data about labor supply. Specifically, the labor force participation rate unexpectedly dropped last month. That disappointment follows a sharp contraction in first quarter US productivity. Without an increase in hours worked or in productivity, aggregate supply will fall short of demand, meaning that the Fed will have to apply the brakes even more firmly to slow inflation.
To be sure, a soft-landing remains possible. But the bar is high. A soft-landing requires some combination of (i) an easing of global supply chain blockages, (ii) an increase in US labor force participation rate, (iii) a surge in productivity growth, and/or (iv) an end to the Russia-Ukraine war and a rapid resumption of food, energy, and other raw materials exports from both countries.
Decoupling is another possible source of hope, as other countries are hesitant to join the Fed in tightening aggressively. Despite surging inflation, the European Central Bank (ECB) remains concerned about growth — understandably so, given the proximity of the Russia-Ukraine war and the potential for energy supply disruptions. The Bank of Japan is also unwilling to tighten because Japanese inflation remains subdued. And, as noted, China faces other challenges. ‘Zero Covid’ will weaken the economy, but ahead of his third-term presidential extension in the autumn, President Xi is apt to ease government spending in the coming months.
Market weakness in 2022 reflects a more uncertain and riskier macroeconomic backdrop than we have seen in a generation. Soaring inflation, aggressive Fed tightening, war, pandemic lockdowns, and supply rigidities make difficult policy decisions even more challenging. The risk of policy error is large.
History does not offer many examples of recession-free Fed tightening cycles. And few of those earlier episodes presented the myriad of unknowns that accompany the present. The runway for a soft landing is narrow and precarious. It will take all the skill the Fed can muster, and probably a dollop of luck, to avoid a hard landing this time.