Limitations

Answer:  Theoretically, the expectation is that higher interest rates will increase slower economic growth by increasing the cost of money. This assumes that the economy is overheated. That’s true in a textbook, but in today’s world there are strong extraneous inflationary pressures which the Fed has no control over. These include the Russia/Ukraine war, oil prices, and continued supply chain disruptions due to COVID lockdowns in some of China’s largest cities. 

The most important drivers of economic activity are consumers, and with high gas prices and overall inflation, many are feeling stressed financially. Recent wage gains and job creation is helping to keep negative forces at bay, but there are limits to consumer resiliency. 

Mortgage rates and housing costs are up. Elevated food and fuel prices, along with other consumer spending components surging contribute to some consumers feeling less wealthy. The tendency is to react accordingly by watching their spending more closely. The upside is that there are roughly 11.5 million jobs available. Filling these positions may help offset the end of pandemic related fiscal stimulus, but this takes time to work through the economy. It’s been said that the cure for higher prices is higher prices. As demand decreases, prices tend to seek equilibrium and decline to meet demand. 

So, what about the Fed? Just last week, Fed Chair Powell stated that the Fed “won’t hesitate” to increase interest rates until prices start to normalize. Expectations show anticipation of a Fed funds rate approaching 3%, the largest annual rate hike since 1994. 

Is perception reality? The Consumer Confidence Board measurement of CEO sentiment shows 57% of respondents expect the economy to sustain a short, mild recession. Recession could become a self-fulfilling prophecy if confidence remains weak. 

Amazon and Walmart, two large employers in the U.S. have indicated their inventory levels grew to record highs in March. This suggests that retailers may have misjudged shifts in consumer spending and could lead to price discounts, placing downward pressure on inflation. As consumers become more cost conscious in response to the progressive tax of inflation, they move to lower cost generic options. Money saved in one area is likely spent fixed on necessities like fuel. 

In efforts to keep customers, Procter & Gamble introduced EZ-squeeze dish detergent bottles to eliminate wasting even a drop of their product and advertises the efficiency of its laundry detergent. Clorox will increase promotions if consumers display more cost-conscious behavior.

The question remains; how much action by the Fed to raise rates is necessary if the economy organically slows in response to inflation? If the Fed hopes to achieve a soft landing as it did in 1994, it will likely have to raise rates methodically and thoughtfully. If the Fed is successful in delivering a soft landing the equity market could be poised for recovery. If a recession were to occur, it is important to interpret whether it will be mild, moderate, or severe. 

Given the overall health of consumer and corporate balance sheets as compared to the 2008 recession, it follows that if we have a recession, it will likely be mild/moderate. 

It appears a 50-basis point rate hike by the Fed is priced into the market for the June and July Fed meetings. Assuming inflationary pressures remain elevated due to circumstances beyond the Fed’s control, it will be a delicate dance to slow the economy while doing no harm to the labor market. Stay focused and plan accordingly. 

The opinions expressed are those of the writer as of May 29, 2022, but not necessarily those of Raymond James and Associates, and are subject to change at any time. This material is provided for educational and informational purposes only. Past performance is no guarantee of future results. There is no assurance the trends mentioned will continue or that forecasts discussed will be realized. Economic and market conditions are subject to change. All investments are subject to risk, including loss. Material is provided for informational purposes only and does not constitute a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete.