US recession concerns are mounting, but still high inflation is underscoring the wide consensus among US policymakers for tightening up monetary policy further, with virtually unanimous support for a 75bp rate rise this month. There is talk of an even bigger 100bp boost at the next meeting.
Such a move would echo that by the Bank of Canada (BoC) which raised rates by a full percentage point on Wednesday (13 July), making the BoC the most aggressive central bank to date. Its policy tightening coincides with the US reporting another 40-year high in inflation with CPI at 9.1% YoY and the euro exchange rate reaching parity with the US dollar for the first time in more than 20 years.
Policy hawks charged up
Rapidly rising prices, deteriorating real incomes and tighter financial conditions are threatening to push the US economy into recession. However, the crucial recessionary ingredient – a broad-based contraction in employment – is still missing.
Indeed, the US economy added 372 000 non-farm jobs in June, rather more than the 100 000 jobs expected by analysts. The unemployment rate held at 3.6%, with average labour earnings growing at a still strong 5.0% YoY.
Even before the inflation report, many Federal Reserve policymakers had judged at their FOMC meeting in June that a significant risk now facing the Fed was that elevated inflation could become entrenched. The public could begin to doubt the Fed’s resolve to tighten policy enough to maintain price stability. Indeed, this was the argument the BoC used to justify its 100bp rate rise.
The most notable shift in the FOMC’s tone was a growing acceptance that growth might have to be sacrificed to restore price stability. Meeting participants reckoned that a return to 2% core inflation was critical to achieving maximum employment on a sustained basis. Thus, there was a lot of tough talk about ‘resolve’ and ‘credibility’.
Relative to the May FOMC minutes, the committee was more convinced of the need for restrictive policy.
The latest inflation data has prompted the market to assume that the FOMC may raise rates by 100bp at its next meeting, in which case we could see an even stronger dollar, higher yields, and a further selloff of equities.
Times have changed
Historically, the Fed has often reacted to a significant drop in stock prices with accommodative policy.
Examples include the 1987 stock market crash, the 1995 economic downturn, the 1998 Asian financial crisis, the 2010 eurozone debt crisis, the 2014 oil crash, and the 2018 stock market shakeout. These all prompted either a pause in monetary tightening or a policy reversal from tightening to easing.
This predictable Fed policy reaction was dubbed “the Fed put” by the market. With the more than 20% decline in the S&P 500 equity index so far this year and recession concerns mounting, will the Fed blink?
Fed policy – More of the same
We do not think so. Recent statements and actions have shown that policy has decisively tilted towards fighting inflation, even at the expense of economic growth. This is because a recession is often necessary to push inflation down. In the 1970s, for example, sustained high inflation led the Fed to keep raising rates, even though stocks had already fallen sharply.
From the Fed’s perspective, once the inflation genie is out of the bottle, the battle to return it to the bottle is often long and painful. The problem today is obvious: inflation measures — including the CPI and the Fed’s favourite, the personal consumption expenditure (PCE) index — are soaring (Exhibit 1) amid rising wage growth in a tight labour market.
A decline in headline CPI as a result of the recent drop in oil prices, may therefore not be enough to appease the Fed. The rise in US inflation is broad-based. We suspect that the bar for a dovish policy shift will be high and that the Fed will likely err on the side of keeping monetary policy tight until the (core) inflation beast has been tamed.
Europe faces similar challenges as the US does, with the ECB obliged to slow the economy to tame core inflation, although not quite on the same scale as the US. The key concern here is the possibility of Russian gas supplies being cut. This would plunge Europe into a deep recession.
Additionally, the eurozone economy faces the worry of weaker export markets as the global growth outlook worsens, while the steep rise in energy prices is already squeezing disposable incomes, hurting consumer confidence, and inflating the costs of doing business, especially in energy-intensive segments of European manufacturing.
These headwinds could overwhelm the boost to economic activity from the post-Covid economic opening (e.g., in tourism) and the fiscal stimulus of the Next Generation EU programme.
Inflation is likely not going away in Europe anytime soon, leaving the ECB unable to cut rates as the market seems to expect early next year. However, the ECB’s policy action is still expected to be less aggressive than the Fed’s. This means tha euro-dollar parity may not be the bottom for the euro in the near term.