The Fed will certainly raise rates quickly. Looking at the dot chart above, there is a clear indication that rates will be closer to 3% by the end of 2022. Additionally, the Fed will amplify the impact of rate hikes by tightening liquidity. Beginning June 22, the Fed will begin monthly unwinding $47.50 billion in bonds (Treasuries and MBS), rising to $95 billion by September 22. It is this double whammy that really worries the markets.
History may be against US Fed optimism on soft landing
If one reads the fine print of the Fed statement, there is a lot of optimism implicit in it. The Fed believes it would be able to pull off a soft landing for the US economy despite rising interest rates. This means that a spike in interest rates would dampen the rate of inflation (as in the Volcker era), but the impact on growth would be limited. The Fed expects its actions to result in inflation falling to below 3% and unemployment below 4% by 2023.
Former US Treasury Secretary Larry Summers believes that this expectation is unachievable. If the Fed expects a soft landing, then history argues against such a perception. Summers suggests that a soft landing for the US economy with this kind of warmongering is not only difficult, but unlikely. He sees a full-fledged recession in the US economy for the foreseeable future. Here is what the empirical data show on the subject.
Larry Summers and Alex Domash of the Harvard Kennedy School believe that high inflation and low unemployment are strong predictors of future recessions. If you look at the empirical data since 1950, almost every time inflation has exceeded 4% and unemployment has fallen below 5%, the US economy has invariably entered recession within 2 years. Like the inverted yield curve, this combination of high inflation and low unemployment accurately predicts recessions.
Why will the inflation-unemployment combination trigger the recession?
According to projections by Larry Summers and Alex Domash, US inflation is currently at 8.5% while unemployment is at 3.6%. Under these conditions, if the Fed adopts a severely hawkish approach, then a recession will be difficult to avoid. Soft landing, may still be a far-fetched wait. The question is; what is this link between the inflation-unemployment combination and an imminent recession?
Here is the explanation! Typically, inflation is the result of too much demand chasing a limited supply of goods. This is the current situation. The Fed is trying to kill demand by raising rates to prohibitive levels. There are 3 issues the Fed could face.
a) The consensus is that inflation should have been brought under control when it crossed 3%, not when it crossed 8.5%. Due to its post-COVID debt overhang, the Fed has delayed rate hikes. At 3-4% inflation, a soft landing might still have been possible.
b) An important aspect is the unemployment rate at 3.6%. This means that the demand for labor is significantly higher than the supply, which has led to higher wages. This means that even amid higher rates caused by the Fed, demand could stay strong for longer and far exceed supply. This may delay the decline in inflation and force more aggressiveness.
c) This could be aggravated by the fact that high interest rates would seriously hamper investment, meaning that supply would still struggle to catch up with demand. Summers and Domash fear that the net effect of all these factors could be a sudden collapse in demand, production and jobs, triggering a severe recession.
The moral of the story is that if the Fed sticks to its hawkish trajectory, a hard landing could be hard to prevent.
Rising Rates and Soft Landings – The American Experience
If you look at the US economy since the turn of the 20th century, there have only been a handful of times when a spike in rates hasn’t led to a recession. The two most recent cases date back to 1984 and later in 1994. In both cases the Fed opted for aggressive rate hikes, but it did not lead to a recession. However, does this miss the fact that the macroeconomic situation in those two years was very different from what it is today?
In both years the unemployment rate was much higher and the inflation rate was much lower than it is today. Today, the problem is the combination of 8.5% inflation and 3.6% unemployment. As has been said many times, working conditions in the United States have never been stricter and companies are forced to raise wages just to attract workers. Wage growth now stands at 6.6% in the United States.
Does this have implications for the Indian economy?
Of course, any US recession will not be an isolated phenomenon. This will have a huge impact on sectors such as IT, pharmaceuticals and automotive auxiliaries. The United States remains India’s largest trading partner and a US recession means weaker demand for Indian goods abroad. Importantly, if the United States were to slow down, there would be a slowdown in the flow of active and passive funds to Indian markets. This is not good news for a market that relies heavily on global liquidity.
Ultimately, there is a high probability that the US economy will plunge 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 hopefully be much lower.