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Why the Window for an Economic Soft Landing Has Narrowed
Central banks are acknowledging that aggressive rate hikes may lead to recession, slimming the hopes of an economic “soft landing” where growth slows but recession is avoided. Head of Portfolio Solutions for Global Fixed Income Tim Johnson analyzes the Fed’s comments after its most recent rate hike.
Central banks acknowledge that their actions are increasing the probability of recession as they forge ahead with rate hikes in their fight against stubborn inflation. After the Federal Reserve hiked its rate last week, Chair Jerome Powell said that the window for an economic soft landing, where growth slows but recession is avoided, has narrowed. Bank of England policymakers, who also increased their rate last week, are expecting a recession.
Let's take a closer look. Central banks are paying more attention to how rate hikes may impact the economy as evinced by new language in the Federal Open Market Committee statement, which noted, "The committee will take into account the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity." However, that hasn't stopped Chair Powell, European Central Bank President Christine Lagarde, and Bank of England Governor Andrew Bailey from charting aggressive plans to reduce inflation.
Last week, Powell said the Fed is focusing on how fast to hike, how high to go, or how long to maintain high interest rates. He was also clear that policy is not sufficiently restrictive. We expect the FOMC to increase its 2023 median year-end Fed funds rate forecast to 5% or more at the December meeting versus 4.6% in September and the current target range of 3.75% to 4%.
One indication that the Fed funds rate is sufficiently high is when it's equal to the inflation rate. The real Fed funds rate, when taking into account inflation, remains near negative 2%, suggesting the Fed still has a ways to go. The US economy already has slowed as interest rates have risen. The economy shrunk slightly in the second quarter when adjusted for inflation.
While the economy grew 2.6% in the third quarter, net exports largely drove the rebound, and growth in consumer demand decelerated 1%. Market-based indicators, such as the inverted yield curve and widening corporate credit spreads, portend a mild recession. Chair Powell last week said that a soft landing is still possible, but he noted that further rate hikes and continued high interest rates thereafter make a soft landing more difficult to achieve.
As a result of uncertainty over the path of inflation and interest rates, we remain underweight equities outside the US, including emerging markets, and have a modest defensive overweight to cash. Further, given the upside risk to yields and a challenging near-term environment for credit, we remain underweight investment-grade corporate bonds. We hold a modest overweight to high yield, given the composition of the sector and relative valuations. However, uncertainty has been the 1 constant theme in 2022, and we believe it will be with us into the new year.