What awaits the economy with the FED's interest rate hike?

On Wednesday (06/15), FOMC met and announced a 75bps interest rate hike, bringing the central bank's lending rate to 1.5%-1.75%. This is the highest interest rate hike since 1994. In addition, FED also lowered the forecast for this year's economic growth from 2.8% in March to 1.7%. This clearly demonstrates FED's priority in curbing inflation ahead of recession risks. 

However, from a macroeconomic perspective, risks of economic recession and uncontrolled inflation could lead to stagflation. In that case, the economy will take much longer to recover. The only U.S. stagflation lasted throughout the 20 years from 1965-1985, forcing Nixon to abandon the gold standard (Gold Standard).  

In this week's macroeconomic article, Viet Hustler will analyze the impact of this interest rate hike on the credit market, FED's next directions, and the risks of recession as well as stagflation from the perspective of U.S. economic history. 

Market Reaction

Investors' reaction is most clearly shown on the debt market

• Investors who previously held or bought bonds of small and medium-sized enterprises are all panic selling at this time due to concerns about the default risk of these companies if the economy worsens. 

• Accordingly, the US High Yield Index dropped sharply right after FED's announcement of the 75bps base rate hike.

• Bank of America's High Yield Index tracks debt assets of companies with credit rating below investment grade.

•  The 10-year U.S. government bond yield has risen to the highest level in the past 8 years and is expected to exceed 4%, a sign that investors have begun to price in the risk of inflation rising in the future.  

  • However, the rise in bond yields is still not enough to "compensate for losses" for the escalation speed of inflation as real interest rates remain negative.

• The spread between 30-year T-bill and 10-year T-bill inverted to negative for the first time since the 2006 inversion (inverted yield curve), right before the 2008 economic crisis period. This is a warning sign that the economy may slow growth in the coming years. 

• Rising borrowing rates are further depleting the U.S. treasury and narrowing the space for fiscal policy as interest payment costs rise.

Contrasting reactions from economists and stagflation risks  

Ahead of the FOMC meeting on 06/15, even though the market bet 97% on FED hiking rates by 75bps, nearly half of the economists (86/182) in Bloomberg's survey still believed FED should only hike by 50bps in the recent meeting.

Lindsey Piegza, Chief Economist at Stifel, warns that raising rates too high in a short time will cause growth to stall abruptly, leading to economic recession. According to Piegza:

• FED should navigate more gently because raising the base rate can only reduce demand for goods from consumers. Meanwhile, consumption has recently trended slower due to negative trends in real income and the household savings rate. 

• What needs to be done is to address the supply shock from the war and the consequences of disrupted supply chains after a long period of the pandemic.

Economists are also concerned that FED's aggressive rate hikes may fail to curb inflation but instead trigger an economic recession. Therefore, more dangerous than recession could be the risk of stagflationfor the economy. 

• Stagflation occurs when economic growth stagnates, unemployment is high, and inflation remains at double-digit levels.  

• The risk of Stagflation will be analyzed more clearly at the end of the article from the perspective of economists.

FED's direction in monetary and economic policy

Projected monetary policy and macroeconomic indicators forecast

• FED will continue to pursue tight monetary policy, at least until 2023: 

  • FED interest rates are expected to rise to 3.4 by the end of this year and 3.8 by the end of 2023, much higher than the previous forecasts of 1.9 and 2.8.

• FED cuts the growth forecast to 1.7% by the end of this year and next year, much lower than 2.8% and 2.2% from the March estimates. 

  • This clearly shows FED's priority in the battle to curb inflation over economic growth.

• Unemployment rate and inflation remain higher than the March estimates.

• Rate cuts will only begin from 2024:

• Fed has also implicitly signaled that there may be multiple 75 bps rate hikes this year. The market also predicts a 77.7% probability that FOMC will continue to raise rates by 75bps in July. 

What does the above policy indicate?

Overall, it is easy to see that what the FED is doing now is focusing all resources on observing and controlling consumer spending. In which, the FED can only curb inflation in the core CPI and core PCE baskets. This is understandable because energy and food prices are rising mainly due to supply chain shocks and the Russia-Ukraine war, which are beyond the FED's control. 

However, food and energy prices are the main causes pushing up the overall CPI index. The domino effect on rising airline ticket prices and transportation costs for other goods is the main reason keeping the core CPI at high levels. 

The fastest way to bring energy prices back to previous levels is to end the Russia-Ukraine war as soon as possible. The Biden administration is probably thinking in this direction. Therefore, instead of using government resources for subsidies to the domestic supply side, Biden has bet on Ukraine by providing an additional $1 billion in weapons to this country in the war with Russia.

Risk of stagflation: perspective from history

Can the FED control inflation without causing an economic recession?

With the current situation, this possibility is very difficult because over the past 30 years, the FED has never raised interest rates higher than the previous peak without causing an economic recession (figure below). 

• Meanwhile, the expected interest rate level that the FED will set in the next 2 years will fall into the range of 3.4% -3.8%, far exceeding the 2020 interest rate peak and nearly equal to the interest rate peak of the 2008-2009 recession.

• This confirms Viet Hustler's view that the FED has prioritized curbing inflation over economic growth. The FED's economic growth forecasts are merely targets to slightly reduce the impact of the economic recession only.

In addition, traders in the Futures market have predicted the trajectory of the cumulative interest rate hikes in this rate hike cycle as shown in the figure below. 

• Accordingly, the cumulative level of this interest rate hike is equivalent to the cumulative interest rate hikes in previous recession periods. 

Clearly, if compared to past economic recession events, the potential for an economic recession due to monetary policy hawkish and aggressive this time from the FED is very high. Unless the Biden administration has sufficient fiscal policies to subsidize key industries and cut government spending. Fiscal policy combined with monetary policy moderately tight from the FED could be an effective tool to curb inflation without causing economic stagnation.

Is there a risk of stagflation?

Stagflation is the concern of economists when both inflation and recession exist like a double-edged sword making it difficult for the economy to recover. In the past, the only stagflation in the US lasted for two decades, from 1965 to 1985 with the triad: high inflation, stagnant economy, and high unemployment rate.

Although the signs of stagflation currently are not clear, economists are beginning to worry about the possibility of inflation surging to double digits, making the FED's interest rate hike efforts futile. At the same time, rising interest rates lead to 2 problems: Reduced economic output leading to recession risk and increased unemployment as companies scale down. To learn more about the impact of interest rate hikes on unemployment and economic output, readers can read the previous macroeconomic analysis by Viet Hustler.

Inflation and economic recession risk

Signs similar to the 1965-1985 Stagflation period

(1) Interest rates rise but inflation is not curbed due to supply shocks, especially oil supply:

The US core CPI index rose rapidly in the late 1960s. In October 1973, OPEC imposed an embargo on Western countries, making the situation worse. The oil and energy fever pushed up transportation and production costs, causing commodity prices to rise and core CPI to grow above 10%.

The current inflation situation has also skyrocketed since the Russia-Ukraine war due to the Western embargo on Russian crude oil imports while US domestic supply is insufficient to meet the economy's demand. Therefore, this supply shock mainly comes from the oil and fuel price shock.

(2) Signs from the financial market

The last time the S&P500 plunged for 10/11 consecutive weeks was during the 1965-1985 stagflation. Currently, S&P500 has also declined in 10 out of 11 consecutive weeks:

Conclusion

Overall, it can be said that the FED's current interest rate hikes clearly demonstrate this agency's determination to curb inflation. However, the bond market and some economists do not support this strong reaction from the FED. From a macroeconomic perspective, economists fear the risk of recession, and even more dangerously, the risk of stagflation for the economy.

However, one of the causes of the 1965-1985 Stagflation must also include the stringent economic policies of that time. At that time, Nixon imposed high taxes on imports, regulated wages and prices for a 3-month period to prevent interest rates from rising. However, the oil price shock at that time still caused supply-side prices to skyrocket. Keeping selling prices and wages even more caused businesses to reduce output and high unemployment, leading to stagflation. The gold standard regime in the early period of this time also limited monetary policy adjustments to inflation. Hopefully, with the tools available in the FED's monetary policy and the US government's fiscal policy, they can mitigate the impact of the recession and prevent the risk of stagflation.