It’s odd that, at the time when the U.S. Federal Reserve has reached new heights in its most aggressive interest-rate hiking cycle in more than a quarter-century, market talk is pivoting to when the Fed will start cutting rates.
But we live in odd economic times. It’s not often that the Fed feels compelled to raise rates in the teeth of an economic downturn.
Even as the Fed announced its second consecutive 0.75-percentage-point increase in its benchmark federal funds rate Wednesday – historically massive leaps, in monetary policy terms – it did so on an ominous note that it placed at the very top of the statement accompanying its rate decision.
“Recent indicators of spending and production have softened.”
Central banks don’t begin their rate-decision statements like that by accident. The Fed is keenly aware that as it attacks sky-high inflation with fast-rising interest rates, it is now doing so against the shift in the economic current.
In the first quarter of this year, the U.S. economy shrank at an annualized pace of 1.6 per cent, and the data since then suggest that the quarter was no aberration. On Thursday, when the U.S. Commerce department releases its first estimate of second-quarter gross domestic product, few experts would be surprised if it reports another small contraction. Consumer spending has slowed. Business investment has slowed. Industrial production and construction have fallen.
Employment and job vacancies are still far too strong to apply the term “recession” to this slowdown. Still, it is a harbinger of what is to come over the next 18 months. The sharply higher interest rates have yet to really dig their heels into economic activity; their slowing effects will deepen and broaden the longer they are in place.
The International Monetary Fund this week forecast that the U.S. economy will grow by a paltry 1 per cent next year, less than half of what the organization forecast just three months ago. By the end of 2023, the IMF projected, the U.S. may be teetering on the edge of recession. With the risks to the economy tilted “squarely to the downside” (soaring inflation, war in Ukraine, surging interest rates), it wouldn’t take much to push it over the edge.
Against this darkening backdrop, economists and market participants are wondering how long the Fed will keep it up – even as Fed chair Jerome Powell indicated in a postannouncement news conference that the bank still expects to continue raising rates over the rest of 2022 and into 2023.
Over the past few weeks, the bond market has priced in expectations that the Fed will end its rate hikes early next year, and will shift into cutting mode as the year progresses, to the tune of a half a percentage point before year end. It amounts to a bet that a serious slowdown or outright recession is coming by early next year, and that it will force the Fed to reverse course and ease some of the downward pressure on the economy imposed by high rates.
Some of this expectation may be based on historical precedent. RBC Capital Markets chief currency strategist Adam Cole said in a recent research note that over the past five hiking cycles, the Fed has cut rates by an average of one full percentage point within one year after rates reached their peak. By that measure, the bond market’s expectations look pretty modest.
But history is probably less useful than usual in this instance. The downturn in rate cycles over the past three decades has come in an environment of much lower and more stable inflation. Today, the inflation problem implies a greater need to push rates higher, and to keep them there for longer. The inflation-fighting job of monetary policy is simply much bigger today than it has been in other recent rate cycles.
The highly unusual speed of these rate hikes also makes the timing of the cycle near impossible to predict using historical norms. Last time the Fed was in a rate-hiking cycle, it took about three years to get rates from their floor to 2.5 per cent. This time, the Fed covered the same distance in four months.
How that will play out for economic activity – not just in the United States, but in other countries, including Canada, whose central banks have adopted a similar high-speed approach – is a big unknown. Maybe the early slowing of the U.S. economy is an indication that inflationary pressures will cool sooner than expected, and central banks will be able to ease up earlier. Maybe it’s a sign that we’re pushing monetary policy too high, too fast, and at least some countries are doomed to tip into recession – with the huge U.S. economy leading the way.
But Mr. Powell made it quite clear in Wednesday’s news conference that the Fed’s priority is to wrestle inflation into submission, even if that risks setting off an economic downturn and an erosion of labour markets.
“Those are things that we expect, and we think that they’re probably necessary if we are to get inflation back down on a path to 2 per cent,” he said.
“Restoring price stability is just something that we have to do. There isn’t an option to fail to do that.”
Your time is valuable. Have the Top Business Headlines newsletter conveniently delivered to your inbox in the morning or evening. Sign up today.