In the aftermath of the 50 bps rate by the US Fed on 04th May, there is a popular joke doing the rounds in markets. What is the similarity between Jerome Powell and a gymnast? The answer is; both will realize that soft landing is the hardest part of the job. In a lighter vein, this captures the reality that only the easier task of raising rates and talking hawkish has been accomplished by the Fed. Now, comes the tougher task of ensuring the US economy does not dip into a recession (2 consecutive quarters of negative growth).
Fed starts on an aggressive note, but is it too aggressive?
When the May-22 FOMC meet started, the Fed had a single point agenda. Inflation had to be curbed quickly by raising rates and making money dearer. Fed not only raised rates by 50 bps in May-22, but also gave a clear signal that rates would go up by another 175-200 bps by end of 2022 to a level of 2.75%-3.00%.
Fed will certainly hike rates rapidly. If one looks at the dot plot chart above, there is a clear indication that rates would be closer to 3% by the end of 2022. In addition, Fed will amplify the impact of the rate hikes by tightening liquidity. Effective Jun-22, the Fed will start monthly unwinding of $47.50 billion of bonds (treasuries and MBS), scaled up to $95 billion by Sep-22. It is this double whammy that markets are really worried about.
History may be against the US Fed optimism on Soft Landing
If one reads the fine print of the Fed statement, there is a lot of optimism that is implicit in it. The Fed believes that it would be able to achieve a soft landing of the US economy despite raising interest rates. That means, a spike in interest rates would curb the rate of inflation (like in the Volcker era) but growth impact would be limited. Fed expects its actions to result in inflation receding to under 3% and unemployment remaining under 4% by 2023.
Former US Treasury Secretary, Larry Summers, feels this expectation is impractical. If the Fed expects a soft landing, then history is against such a perception. Summers suggests that a soft landing of the US economy with this kind of hawkishness is not only difficult, but improbable. He sees a full-fledged recession in the US economy in the foreseeable future. Here is what the empirical data on the subject shows.
Larry Summers and Alex Domash of the Harvard Kennedy School opine that high inflation and low unemployment are strong lead predictors of future recessions. If one looks at empirical data since 1950, almost each time inflation exceeded 4% and unemployment fell below 5%, the US economy invariably went into recession within 2 years. Like the inverted yield curve, this combination of high inflation and low unemployment predicts recessions accurately.
Why will the inflation - unemployment combination trigger recession?
If we go by the projections of Larry Summers and Alex Domash, currently, US inflation is at 8.5% while unemployment stands at 3.6%. In these conditions, if the Fed adopts a harshly hawkish approach, then a recession will be hard to avert. Soft landing, may still be a far-fetched expectation. The question is; what is this link between inflation-unemployment combination and an impending recession?
Here is the explanation! Typically, inflation is an outcome of too much demand chasing limited supply of goods. That is the situation now. The Fed is trying to kill demand by raising rates to prohibitive levels. There are 3 problems that the Fed could face.
a) The consensus view is that inflation should have been controlled when it crossed 3%, not when it has crossed 8.5%. Due to its post-COVID overhang, the Fed delayed rate hikes. At 3-4% inflation, soft landing may have still been possible.
b) An important aspect is the unemployment levels at 3.6%. That means demand for labour is sharply higher than supply and that has led to higher wages. That means, even amidst higher rates caused by the Fed, demand could still remain strong for longer, and well in excess of supply. This may delay the fall in inflation and force more aggression.
c) This could get compounded by the fact that high rates of interest would seriously curb investments, which means supply would still struggle to catch up with demand. Summers and Domash apprehend that the net effect of all these factors could be a sudden collapse in demand, output and jobs, triggering a serious recession.
The moral of the story is that if the Fed sticks to its hawkish course, then a hard landing may be tough to prevent.
Rate hikes and soft landings – The American experience
If you look back at the US economy since the start of the 20th century, there have been only a handful of occasions where a spike in rates did not result in a recession. The two most recent cases are in 1984 and later in 1994. In both these cases, the Fed went for aggressive rate hikes, but it did not result in a recession. However, that misses the point that the macro situation in these two years was very different from what it is today?
In both the years, rate of unemployment was much higher and the rate of inflation was much lower than what it is today. Today, the problem is the combination of 8.5% inflation and 3.6% unemployment. As has been reiterated time and again, labour conditions in the US have never been so tight and companies are being forced to raise wages just to attract workers. Wage growth today stands at 6.6% in the US.
Does this have implications for Indian economy?
Obviously, any US recession will not be an isolated phenomenon. It will impact sectors like IT, pharma and auto ancillaries in a big way. The US remains India’s largest trading partner and a US recession means weaker demand for Indian goods abroad. Above all, if the US slows down, there would be a slowdown in active and passive fund flows into Indian markets. That is not good news for a market reliant on global liquidity in a big way.
The bottom line is that there is a high probability of the US economy dipping into recession. Even with a proactive policy approach, India cannot avoid the impact. Of course, for an inward looking economy like India, the impact would be, hopefully, much smaller.