Better to Have Loved and Lost… Rate Hikes and the Economy

By Diane Swonk, Chief Economist, Grant Thornton

Wall Street’s love affair with low rates and the Federal Reserve is about to come to an abrupt end. Fed Chairman Jay Powell all but promised to start raising rates in March following the January Federal Open Market Committee (FOMC) meeting. He said that “…it will soon be appropriate to raise the target range for the federal funds rate.”

He warned that a drawdown in the Fed’s $9 trillion balance sheet could soon follow. He said that the balance sheet reductions would be more “orderly and predictable” and in the “background.” The Fed would like short-term rate hikes to be the primary tool against inflation. Reductions in the balance sheet, officials hope, will be less noticeable and akin to watching paint dry.

The Fed is now expected to raise the target on the fed funds rate five times by 1.25% in 2022, starting in March. It could announce plans to reduce its balance sheet as soon as June. The Fed would prefer to hold Treasury bonds over mortgage-backed securities, which is one reason that mortgage rates have moved up even faster than Treasury yields in recent weeks.

At least one of the hikes this year could be one half instead of one quarter percent. Why the urgency?

  • The inflation we are enduring is global in scope;
  • has far exceeded the expectations of central bankers at home and abroad; and
  • risks becoming entrenched and baked into wage gains, much like we saw in the 1970s when stagflation occurred.
Fed Hits Brakes On Growth

 Real GDP is expected to slow to a 1.5% pace in the first quarter, almost one fifth of the 6.9% pace we saw in the fourth quarter of 2021. Disruptions triggered by the Omicron wave are the primary reason for the weakness. Spending on goods held up better than spending on services. Reservations and walk-ins at restaurants plummeted. Throughput at TSA checkpoints dropped. Hotel occupancies fell. Movie theaters emptied. Home buying and building treaded water as shortages and weather delays mounted. Inventories likely drained; the trade deficit is expected to hold steady. The outlier is business investment, which had a tailwind entering the year.

Real GDP is forecast to rebound at a 3.2% pace in the second quarter. Bookings for spring break have picked up; some popular vacation spots are already sold out. Home buying and building is expected to begin to feel the bite of higher interest rates along with business investment. Inventories are expected to rebuild, while the trade deficit is expected to improve. Gains in state and local government spending should offset a drage in federal spending.

Growth for all of 2022 is forecast to average 3.3%. That marks a sharp slowdown from the 5.7% pace we saw in 2021, but is still strong. Unemployment is forecast to dip to 3.2% by year-end, the lowest since the early 1950s. Participation in the labor market is expected to remain lower than it has been in decades in 2022.

The Fed can’t risk that; it has already suffered a blow to its credibility by letting inflation persist this long.

Pandemics usually boost wages but not inflation. This time was different. The hope was that the loss of life would be contained by leveraging the science that our forefathers lacked. We failed; excess deaths are now on par with previous pandemics. The Delta variant was particularly hard on younger workers.

This is at the same time that technology and unprecedented fiscal and monetary stimuli helped blunt the blow to demand. Larger swaths of the global economy pivoted to working from home and retained their paychecks, even as fear of contagion spread.

Those who could bought everything possible to ease the monotony of quarantines. Purchases of homes, furniture, RVs, boats, vehicles, electronics, furniture, appliances and exercise equipment skyrocketed. Shortages erupted and prices flared.

This edition of Economic Currents takes a closer look at how the economy is likely to weather rate hikes by sector. This is the first time the Fed has had to chase inflation since the 1980s; it will be painful.

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