By the BlackRock Investment Institute
A flurry of central bank moves last week has revealed many are ignoring the crushing effect this will have on growth. This dynamic raises serious growth risks, and we now see the U.S. restart of economic activity stalling over the coming quarters. The focus is on the Fed – and we think it will ultimately change course but not before causing growth to stall. This raises the spectre of growth weakness but still persistent inflation. We don’t see this as an environment for buying the dip.
Chart of the week
Fed funds and GDP growth projections by meeting
The Fed’s updated “dot plot” of the Fed funds projection shows it’s ready to push rates to nearly 4% by next year (red line, left chart). This takes rates well beyond neutral of around 2.5% – the level that neither stimulates nor decreases economic activity. Yet the Fed continues to forecast trend-like growth (red line, right chart). Financial conditions are already quickly tightening. And with growth slowing elsewhere and higher energy prices, we expect a worsening macro environment for the rest of the year and into 2023. The Fed isn’t looking for a recession, even though in our view one would be needed if it wanted to drive inflation back down to 2%. So we expect the Fed to change course once it becomes clear growth has stalled.
The Fed seems dead set on raising rates this year to levels that, in our view, would clearly slow the economy. It seems to be responding to the “politics” of current high inflation. But the Fed isn’t actually looking to slow the economy. Fed Chair Jerome Powell said the central bank is not trying to induce a recession. This reflects the Fed’s lack of acknowledgment of the policy trade-off. Current high core inflation rates reflect an imbalance of demand and supply broadly across the economy. It isn’t due to overheating demand but unusually low production capacity in an incomplete restart following the pandemic.
In fact, the Fed is facing an acute trade-off: either slam down activity or live with persistent inflation while production capacity recovers. The Fed hasn’t acknowledged this. It assumes that a rapid return of supply capacity will help resolve high inflation – so any upside surprise to inflation will push it toward tighter policy, and a downside surprise on inflation won’t necessarily slow it down. If the Fed jacks up rates and then changes course as we expect, it still raises the risk of zero or negative growth and persistent inflation. When the macro environment is shaped by production constraints, the Fed can’t avoid volatility. It can only trade inflation volatility for output volatility – a big theme at our 2022 Midyear Forum last week. We may be set for both, posing a further drag to risk assets.
How does the inflation/growth trade-off play out elsewhere? We think the European Central Bank (ECB) will be forced to confront reality sooner because the euro area will feel economic pain sooner. The ECB’s planned policy normalisation under-appreciates the risk of the energy crisis pushing the euro area into recession. The ECB’s troubles are seen in the peripheral bond volatility that sparked an emergency meeting last week to help steady financial conditions across the euro area.
That comes as the Swiss central bank and the Bank of England (BOE) also raised rates last week, with the BOE warning of recession risks. The BOE is closer to acknowledging the policy trade-off and could decide to go slow on further rate hikes. The Bank of Japan bucked the trend, keeping its ultra-accommodative stance, largely because inflation remains low and Japan did not have harsh lockdowns driving the inflation volatility in other major economies.
What does this all mean for investments? We already reduced portfolio risk twice this year on growing concerns over the effect of the energy crunch on growth and central banks over-tightening. This is why we don’t see the risk asset retreat as a reason to buy the dip – and expect more volatility ahead.