The world economy is facing headwinds. The US economy is in good shape to weather the turbulence. Much is in the hands of the Federal Reserve, which is determined to bring inflation down. Can the Fed steer the economy towards a better future through the narrow corridor, without either driving the economy into a deep recession or letting the inflation genie out of the bottle?
Leo Tolstoy’s novel Anna Karenina starts with the well-known phrase, ‘All happy families are alike; each unhappy family is unhappy in its own way’. The main economic areas of the world are indeed unhappy in their own ways.
European economies are suffering from the war in Ukraine and the associated energy crises and the loss of consumer and business confidence. In China, the lockdowns are still the primary policy tool used to contain COVID-19 outbreaks, which are once again gaining strength. Amid the pandemic, it seems that China still can’t protect its people and keep the economy rolling simultaneously. The highly indebted construction sector also shows renewed signs of weakness. In the US, the cyclical position of the economy is much stronger than in Europe or China, and the looming recession is mainly driven by the Fed’s attempt to rein in inflation through rapid interest rate hikes.
The global economy seems to be slipping into a synchronised recession next year. The Institute of International Finance, which is the global association of the financial industry, forecast just last week that global GDP will grow by only 1.5% in 2023. During previous decades, the world economy has witnessed weaker growth only in 2009 during the Great Financial Crises and again during the COVID-19 pandemic in 2020.
In the US, the Fed is determined to bring inflation down. It is clear, that the Fed can’t do it without a considerable slowdown in private consumption and investments, and a rise in unemployment. The Fed faces two challenges in fighting against rampant inflation.
The first challenge is the resilience of the real economy despite the exceptionally rapid monetary policy tightening cycle. Households have just kept on consuming despite higher interest rates. The latest retail sales figures from October were strong, and in labour markets job creation has stayed solid, with an average of around 300 000 new jobs created during recent months. Wage growth is also robust with hourly wages up around 6% year-on-year. One reason behind strong consumption is excess savings, which were accumulated during the pandemic thanks to generous support measures from the government.
The second challenge is the endogenous loosening of financial conditions. Market expectations of the pace of monetary policy tightening have moved towards slower pace of rate hikes and lower ‘terminal rate’, that is, the highest point of the Fed funds target rate during the tightening cycle. This change has lifted the equity markets and brought longer dated treasury yields down.
These two challenges imply, that the Fed needs to hike rates even higher than currently expected to get the desired impact on the real economy and price developments. Inflation is still running hot, even though October inflation print was lower than expected. Headline CPI inflation eased from 8.2% to 7.7%, and perhaps more importantly, core CPI, which excludes volatile energy prices and food prices, came down from 6.6% to 6.3%. It is too early to say, whether October figures were just a lucky one-off, or a beginning of a disinflationary trend.
There is one important matter, which speaks for a more cautious tightening cycle onwards. The Fed started the tightening cycle only 8 months ago in March. The steering rate is currently 3.75 percentage points higher than in the spring. Monetary policy operates with ‘long and variable lags’, as Nobel laureate Milton Friedman taught us already in the late 1960s. The full impact of the changes in monetary policy stance transmits to economic activity and prices in 6 to 24 months. So, there is a real danger that policy tightening goes too far driving the economy into a deep recession. Doing too much is equally as dangerous as doing too little.
The strengthening trend of the US dollar has supported the disinflation in the US. At the same time, it has raised concerns around the world. In Europe, weakening currencies are ‘importing’ inflation through higher import prices. But the true problem is with emerging market countries, which are funding themselves in dollar-denominated bonds. These countries are forced to hike their interest rates to support their own currencies vis-à-vis the US dollar. ‘The dollar is our currency, but it’s your problem’, as President Nixon’s Treasury Secretary told his European counterparties in the early 1970s.
Why did the US dollar strengthen during the 16-month period ending in September by over 20% vis-à-vis the Euro, and what is behind the dip in recent weeks? There are at least three factors behind the strengthening trend.
A strong economy tends to support the currency. And the US economy has been strong both in absolute and in relative terms. In Europe, the rapid deterioration of the current account balance due to the energy price shock and weakening export demand has weakened the Euro against the US dollar.
Another factor behind the strengthening of the US dollar is the interest rate differential, which is due to the Fed’s tightening cycle. Other central banks have followed the Fed, but the Fed has been the first mover. The US dollar has also gained from safe haven demand. When uncertainty in the world economy increases, capital flows typically turn towards the US.
The recent dip of the US dollar against other major currencies looks like an overreaction. The US dollar has depreciated against the Euro by around 8% during October and November. Dovish Fed communication and softer inflation figures in October brought this about. In my view, the Fed still needs to tighten monetary policy considerably to get inflation under control.
Is the trend of strengthening US dollar about to change? Well, not necessarily. Despite the economic headwinds, in relative terms the US economy will continue to outperform its peers. The interest rate differential may also persist, even though the Fed would ease the tightening cycle. The other central banks will most likely slowdown their rate hikes right after the Fed does it.
And a reduction in the safe haven demand for the US dollar requires that elevated uncertainty in the global economy eases. As long as the war in Ukraine continues and the policies to contain the COVID-19 pandemic in China create economic disturbances, the safe haven demand continues to support the US dollar.
The recent rally in the equity markets and in the treasury market was ignited by the dovish Fed and benign inflation data. The broad S&P 500 stock index is up by around 12% from the mid-October bottom, and the 10-year treasury yield is down by 0.5 percentage points. Much is not needed to reverse the rally. One higher inflation print will do the trick.
November inflation figures will be released just one day before the Fed releases its December monetary policy decisions. Currently the markets expect the Fed to hike the Fed funds target range from 3.75%-4.00% by 0.50 percentage points in December after several larger hikes during the current year.
The futures market prices the ‘terminal rate’ of the Fed funds rate to the 5.0%-5.25% range early next summer. This is in line with the hawkish members of the Fed commenting that the terminal rate should be at least around 5%. The market view that rates will come down about 0.50 percentage points before the year end 2023 looks too optimistic. Inflation in the US is so broad-based that interest rates need to stay elevated longer to make sure that inflation is driven out of the system.
What’s ahead in the equity and bond markets in the US? The recession has not even started. It is quite unlikely, that the equity markets would bottom out before the recession takes hold. I would expect that things need to get worse before they get better.
The same applies to the government bond markets. I believe that the Fed needs to go higher with the Fed funds target rate than currently anticipated, and the rates need to stay high longer. Another thing is that the Fed has started shrinking its balance sheet, which will push treasury yields higher.
The world economy is facing headwinds. The US economy, however, is in far better shape than many other areas to weather the turbulent times. If the Fed succeeds in its difficult job of bringing inflation down with moderate losses in output and jobs, the dynamic US economy will soon bounce back.