A "Growth Recession" is on the Horizon
What Federal Reserve Chairman Jerome Powell has to tell us about where we're heading
Thursday, September 1st, 2022
The Market's performance was mixed today after four down days as investors test out if the recent sell-off has slowed. Market indices saw some gainers and losers.
The S&P 500 rose by 0.30%
The Dow Jones increased by 0.38%
The NASDAQ edged lower by -0.26%
The Russell 2000 fell by -1.15%
Despite the mixed day for the Market, the overall outlook on Wall Street remains grim. The stock market rally of July, much like it did in March, screeched to a halt following comments from the Federal Reserve. Since last Thursday, the S&P 500 has fallen by more than 5%, giving up much of its gains since mid-July.
Why? It all has to do with monetary policy.
At last week's Jackson Hole Economic Summit, Federal Reserve Chairman Jerome Powell delivered some bad news: there's no soft landing ahead. And his words have investors running for shelter as they forecast how much more interest rates will climb and decipher what this means for the economy.
After messaging earlier in June that he was hoping the US Central Banking system could cool inflation through credit tightening without inducing a recession, Chairman Powell seems to have conceded that the US economy may need a bit of a slowdown. Specifically, Powell admitted that the US had some "Pain" ahead and that the Fed would continue its aggressive monetary policy to fight inflation and "keep at it until the job is done."
His statements were a remarkable change of tone from a year ago when the Federal Reserve was wholly focused on bringing down the unemployment rate and called inflation "transitory." But since then, we've seen skyrocketing energy prices, mainly due to higher consumer demand and the ongoing war between Russia and Ukraine.
Powell's change of tone foreshadows a continued cycle of interest rate hikes through the end of 2022 and into the following year, along with tightening measures. So what specific policies are the Federal Reserve using to fight inflation?
1. Interest Rates:
Well, this one is obvious. Since the start of the year, we've gone from a target base interest rate of 0.00%-0.25% to 2.25%-2.5%, making debt more expensive for everyone, from companies to consumers. This benchmark rate affects everything from mortgage rates and car loans, which demand a premium (or higher interest rates).
The Fed hopes that making debt more expensive will crimp consumer demand, thus causing prices to stay flat or drop. We've already seen evidence of this working in the real estate market, where housing prices are falling. However, as a result, rents have snuck back up to pre-pandemic levels for major cities such as Los Angels and New York.
Interest Rates will continue to rise in 2023 to close to 4%
The Federal Reserve is likely to raise interest rates again at the end of September by another 0.5% to 0.75%—bringing the target range to somewhere between 2.75%-3.25%. And its Open Market Committee members expect it to peak at 3.8% before falling in 2024.
2. Open Market Operations:
The Federal Reserve is the largest purchaser of US government debt, aka US Treasuries and government-backed mortgage loans. And during the Pandemic, it purchased close to $4.8 trillion of government debt to fund economic relief and subsidies to keep the economy running. But now that the Pandemic has passed and businesses have reopened, the Federal Reserve is starting to sell this debt to investors to reduce its balance sheet of $9 trillion.
The Federal Reserve started to sell its holding of US debt last year but plans to double its sales from $48 billion to $95 billion per month beginning this month. As the Fed sells its assets, it effectively pulls money out of the economy since private investors buy these Treasuries rather than investing in other assets or making loans.
3. Behind-the-scenes banking policies:
While not often in the news, the Federal Reserve has a lot of requirements for banks (such as Chase and Bank of America) that it uses to regulate the amount of money (liquidity) in the economy. One of the key tools is the amount of money that the Federal Reserve requires banks to keep in reserve.
Banks constantly have money flowing in and out as they make loans and receive payments. But every day, they need to have a certain amount of money reserved to accommodate a bank run (i.e., many people want their money all at once).
If a lot of money flows, prices tend to elevate, as evidenced by startup valuations and housing prices. But the reserve requirement regulates the amount of money a bank can loan, and when the reserve requirement amount is higher, banks can't lend as much to other banks, companies, and consumers.
During the Pandemic, the Federal Reserve waived banks' reserve requirements in 2020 to free banks to lend freely. But now that the economy is too hot to handle, it wants to do the opposite. Starting on October 1st, the Federal Reserve will reintroduce reserve requirements for banks and limit their ability to lend. As a result, the number of loans will fall, and as a result, the cost of capital may rise as banks need to recover lost revenue.
A Growth Recession
Now that Fed Chairman Powell has seemingly gone all in on taming inflation, what does that mean for the economy? Some prominent economists are forecasting a "Growth Recession" in which the US doesn't necessarily fall into a full-blown economic contraction but is stuck in a period of muddling growth below 2% with rising unemployment for a few years. Think of it as a mixture of positive and negative growth, quarter-to-quarter.
With this approach, Chairman Powell is partially emulating the playbook of his role model Paul Volker, the former Fed Chairman in the early 1980s. Volker figured that the only way to deal with the rampant inflation at the time was to shock the economy with sky-high interest rates to induce a recession that would reset price levels.
Now, Powell doesn't seem to want the same deep recession that Volker created to quell inflation. But he wants the economy to slow to the point that it technically is growing but feels like a recession. It’s confusing, we know.
Nonetheless, it seems we're headed for a period of low growth and potential job losses from the historic low unemployment we see today. While that doesn't sound fun, it may be necessary to avert the worst that inflation threatens, which would be a period of stagflation (stagnant growth + high inflation).
And the Market will be increasingly volatile as Wall Street attempts to forecasts what Federal Reserve monetary policy will look like a few years out. Things will be choppy for a while, but preeminent investors always point out that volatility is the perfect time to consider investing to buy low.
In the long run, if history is any indicator, inflation will pass, and the Market will recover.
Stay frosty,
Alex with TAI