September 23, 2022 | 14:29
U.S. Economy: Past the Point of Rescue
When Fed policy starts to resemble a bull in a china shop, you know things are going to break. Initially it’s financial markets, as currently unfolding; and next will be the economy, as financial conditions tighten. Based on our in-house measure, financial conditions are set to carve 2 percentage points from U.S. GDP growth next year. This reflects the punishing effects of the mighty greenback, the angry bear market in equities, wider credit spreads and tighter lending conditions, and assumes another 150 bps of Fed rate hikes and a 15% slide in house prices. At the very least, the financial clouds have the words “shallow recession” written all over them.
Consequently, we now expect back-to-back declines in quarterly real GDP in the first half of 2023. And, unlike the same pattern in the first half of this year, the declines will reflect a broad, sustained decline in economic performance, involving lower employment, production, spending, and incomes. In other words, a real recession that inflicts real pain on households and businesses. The unemployment rate is expected to rise from 3.7% to 5.0% by late next year, before steadying in 2024 as the economy recovers. Though not historically high, the expected rate should ease current worker shortages and cool the inflation flames.
So far, the Fed hasn’t tightened sufficiently to cause serious harm to the economy. Apart from the housing market, most sectors have held their head above water while swimming against the current. Activity even seemed to pick up modestly this summer. But any strength now seems to have faded. The Atlanta Fed’s GDPNow estimate for Q3 growth has tumbled to 0.3% (annualized) from an earlier peak of 2.6%, slightly below our call of 0.6%.
And it’s all downhill sledding from here, with the trajectory hinging on how much more aggressive the Fed needs to get to tame inflation. Prior to the recent unprecedented string of 75-basis point rate hikes, the last time the Fed launched a similar-sized move was in 1994. The combined 300 bps of policy tightening at that time, which took the funds target rate up to 6.0%, led to real GDP growth downshifting by about 2 ppts in 1995. The jobless rate rose only slightly—your archetypal soft landing.
Fast-forward to today, and the Fed has already raised rates by 300 bps and looks dead set on moving an additional 150 bps in the months ahead. This will take monetary policy into highly restrictive territory, causing more material damage to the economy. With 30-year mortgage rates now well above 6%, the highest in 14 years, the housing market faces a more painful reckoning. Moreover, soaring prime lending rates could all but extinguish any pent-up demand that was expected to refuel a supply-challenged auto industry. Yes, excess personal savings will cushion the blow. But with the Fed pledging to restore price stability at all costs, we have likely moved past the point of rescue for this expansion.