Can a hawkish Fed balance the risks and avoid a US recession amid its aggressive rate increases?

The latest meeting suggests there are no doves left as the Fed signals an accelerated path of rate rises to fight a hot summer of inflation
But, with a cooling housing market and strong dollar among factors set to slow growth, an overly hawkish Fed could slow demand and even spark a recession

Clara Cheong

Published: 1:30am, 18 Jun, 2022

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While many had hoped that inflation had peaked in March, the red-hot May data has stirred fresh concerns about the level and persistency of a phenomenon we haven’t really experienced since the 1980s. Following that, the US Federal Reserve decided to raise its interest rates by 75 basis points – three-quarters of a percentage point – the biggest increase since 1994.

The US consumer price index increased 8.6 per cent year on year in May, above the 8.3 per cent consensus expectations. A closer look points to the same main drivers. Energy and food inflation rose by 3.9 per cent and 1.2 per cent respectively from the previous month, on the back of continued supply-side issues worsened by the Russia-Ukraine conflict.

The relatively strong US consumer continued to spur demand in a supply-constrained car market, which saw prices for new and used vehicles rising by 1 per cent and 1.8 per cent respectively from April. Inflation linked to the reopening of the economy was also particularly strong, with airfares up 12.6 per cent for the month and 37.8 per cent for the year.

On the bright side, core inflation (excluding food and energy), which rose by 6 per cent year on year, continued to moderate, while core services inflation picked up slightly due to rising rents.

Although there were some concerns around stickier shelter inflation – derived from housing costs based on rent, not home prices – due to the 0.6 per cent month-on-month increase, surging mortgage rates and home prices that have risen significantly over the past year have crowded many potential homebuyers out of the market.

A “for rent” sign in Houston, Texas, on February 7. Since March 2020, the estimated median rent for new leases has risen by double digits in several Texas cities. The surge in home prices has meant more people are now looking to rent. Photo: AFP

As confidence wanes, the housing market will cool, which should help ease shelter inflation. The reality is that there are many forces acting to slow the US economy. The housing market is one. Throw in a strong US dollar and fiscal drag – as inflation or income growth means people pay more tax and spend less – and a US slowdown grows more certain.

Recognising these risks, the Federal Open Market Committee (FOMC) also published a new set of economic projections, cutting the expected economic growth rate to 1.7 per cent for 2023, with the core personal consumption expenditure inflation rate slowing to 2.7 per cent but the unemployment rate moving up to 3.9 per cent.

While the labour market continues to expand and growth is expected to recover, the committee recognises that the aggressive path of interest rate rises will cool demand for labour and act as another drag on the economy into next year.

Despite the prospective macroeconomic slowdown, Federal Reserve chairman Jerome Powell needs to balance the risks, and doing “too little” is the bigger risk to the economy in his view. What is clear from the latest FOMC meeting is that the Fed is on an accelerated path of rate increases and is committed to fighting inflation.

02:09

US Fed raises interest rates by 0.75 percentage point, the biggest hike since 1994

Importantly, there are clearly no doves left on the committee, given that no members see the federal funds rate being lower than 3 per cent by the end of the year. And, given that inflation may remain high through the summer, it seems possible that the Fed will raise rates by a further 75 basis points in July, 50 basis points in September, followed by 25 basis points in November and again in December.

On the back of the more hawkish path and rate increase trajectory the Fed has laid out, the odds of a recession next year have risen, especially as the Fed has restated its commitment to getting inflation back to its 2 per cent target, which means it may be willing to sacrifice growth to achieve this.

The Fed has the unenviable task of staying patient and maintaining a balanced approach while managing the expectations of people who have lost patience with it. The US central bank needs to stick to controlling what it can control without being overly aggressive in its policy normalisation.

Above all, it must avoid inadvertently slowing demand and triggering a recession to contain an inflation problem with a relatively blunt toolkit.

Clara Cheong is a Singapore-based global market strategist at JP Morgan Asset Management