Rocks In Hard Places

The Credit Strategist - July 2022

While a recession is a virtual certainty (measured in terms of real, not nominal, GDP), we need to step back for a moment and understand what we are talking about when we use that term. While real 1QGDP growth was -1.4%, nominal GDP growth was a still strong +3.5% and 2QGDP numbers are likely to be similar (if not slightly stronger). This means the Fed is going to have to work extremely hard to slow economic growth sufficiently to suppress high single-digit inflation. Raising the Federal Funds rate to ~3% by year-end will still leave real rates meaningfully negative, which will leave the Fed facing the unhappy prospect of raising rates higher than expected. Many seem to be counting on the Fed performing the miracle of quashing inflation with negative real rates, but that isn’t going to happen. Fed Chair Jay Powell is vowing to make fighting inflation his priority but he will be tested as markets bear the brunt of tightening.

Federal Reserve Chairman Powell keeps saying the economy is strong because nominal economic growth is reasonably robust. Only when growth is adjusted downward for inflation and translated into “real” numbers does it look weak – as noted above, +3.5% nominal 1QGDP growth dropped to -1.4% nominal growth after inflation. The same will happen in 2Q22 when high nominal growth is gutted by high inflation. Despite the fact that the Fed is raising rates very quickly by historical standards, it is still early in the game after 150 basis points of interest rate hikes and QT of less than 1% of its balance sheet as of July 1st. We need to see the cumulative effects of more rate hikes and more QT to make an informed judgment regarding how much more tightening will be required and how much the markets (and politics) can bear. But it is premature to believe we are anywhere near the end of this tightening cycle despite the damage already suffered by financial markets. That is not to suggest the Fed won’t pause in 4Q22 to see where things stand, but the likelihood of real positive interest rates capable of truly tightening financial conditions is low. And whether we ever reach that point is highly dubious based on the Fed’s historical behavior.