Fed Foresees Long Low-Growth Period to Fight Inflation
Federal Reserve Chairman Jerome Powell poured cold water on market sentiment during the September meeting when the central banker foresaw a sustained period of below-trend growth before inflation is left behind. The Fed’s 0.75 percent interest rate hike supported the USD, which rose against the EUR, sending it to 20-year lows.
With the US currently in a technical recession, the Fed is wagering that tighter monetary policy and low growth can defuse inflation before the labour market falters and high inflation slips into stagflation. So far, the US jobs sector has maintained robust growth with unemployment at decades-low levels. Still, as the economy weakens, the trend increases the risks towards the US’s employment situation. The central bank forecasts estimated job losses of around 1 million and an unemployment rate of 4.4 percent.
It’s not only the labour market that will see a correction, the housing market will also be affected by a harder recession, according to the Federal Reserve.
"For the longer term, what we need is supply and demand to get better aligned, so that housing prices go up at a reasonable level, at a reasonable pace, and that people can afford houses again.” Jerome Powell.
Are there echoes of the recession triggered by the sub-prime housing crisis in the current economic scenario? This is a good question considering the widespread repercussions of a weak housing sector in the US. On the surface of it, a few of the details seem to show similarities:
- A period of low interest rates from 2003 – 2004 created a bubble in the housing sector.
- The Federal Reserve raised interest rates rapidly from 1 percent in mid-2004 to 5.25 percent in mid-2006.
The differences between then and now are also noteworthy.
The housing market collapsed by 2007 as vulnerable household mortgage holders defaulted on their loans and by the beginning of 2008, the US was in the Great Recession. While we can’t predict the future, in 2022, the jobs market in the US is robust and household loan defaults have not yet become an issue. In addition, there was a vigorous regulatory response to prevent future exposure to the sub-prime loan sector.
The causes of today’s economic headwinds are completely different, they are inflation and an uneven recovery from the COVID-19 pandemic, not defaults in sub-prime loans. Finally, interest rates are on a course to reach 4.6 percent by 2023, still lower than the 5.25 percent seen in 2006. Nonetheless, the level of household debt rose to 16 trillion USD in the second quarter, and given rising interest rates, it’s vital that the jobs sector stays resilient in order to avoid defaults.
Main takeaways
- Risks are rising towards the USD.
Rising risks towards economic growth and the US jobs market can often have an impact on the strength of the USD. The value of the currency has soared along with interest rates, possibly adding to inflationary effects, at least in the crude oil markets which are USD-denominated. If the recession deepens in the US, it may influence investor confidence and weaken the USD in the short-term, thereby going some way to deflate prices in the energy markets.
- US interest rates will head to 4.6 percent by 2023 and 4.4 percent by the end of this year.
Treasury bond markets and banking sector incomes in the US may benefit from rising interest rates as they are sources of cash flow, provided the wider economy supports such developments. On the other hand, mortgage repayment levels will rise in the housing market, possibly slowing down the housing and construction sectors.
- Inflation will be stubborn until post-pandemic effects subside.
While geopolitical factors stemming from Ukraine have escalated inflation, there are alternative crude oil supplies from OPEC and the US. The post-pandemic effects are the most dynamic drivers of future inflation as travel and economic activities pick up around the world, but probably most importantly, in China.
China’s zero-tolerance policy has held back much of the recovery in its industrial heart, affecting the US and other major manufacturing sectors in the global economy. This appears to be coming to an end after China’s Centre for Disease Control advocated a fourth booster COVID vaccine as the way out of the pandemic.
Lastly, the Federal Reserve remains and will stay hawkish for the medium term.
"We have got to get inflation behind us. I wish there were a painless way to do that. There isn't...We will keep at it until we're confident the job is done." Jerome Powell.
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