The most likely economic scenario right now is a recession, said Steven Friedman of MacKay Shields at a Nordea Asset Management webinar. Still, he believes U.S. monetary officials will get inflation under control.
2022 has been extremely difficult for investors so far. The further development of the stock market is likely to depend not insignificantly on whether the U.S. manages a soft landing or whether the country slides into a recession. As Steven Friedman, senior macroeconomist at MacKay Shields, said in a Nordea Asset Management webinar, recession is the far more likely scenario.
"A soft landing historically succeeded in the U.S. only when inflation was either low or at least about to moderate significantly", he explained. Neither applies to the current environment, which leaves little room for the Federal Reserve to maneuver, he said. Accordingly, the Fed is likely to continue to focus on containing inflation and less on the economy. There is also a prevailing assumption in the markets that monetary policy needs to be tightened even more.
The fed funds rate is already higher than the neutral interest rate level
As can be seen on the chart, the estimated neutral policy rate has been falling steadily over the past decades. This is defined by the Dallas Federal Reserve as "the short-term real interest rate consistent with maintaining full employment and the associated price stability in the economy" defines. Thus, the neutral policy rate is the theoretical policy rate at which the Federal Reserve's monetary policy stance is neither expansionary nor restrictive.
"If the Fed raises the federal funds rate above the level of the estimated neutral policy rate, as it is currently doing, a recession will inevitably follow", Friedman explained.
However, a significant portion of inflation is currently driven by supply-side issues, she said, as well as high energy prices, which the Fed has little ability to influence. With inflation in the service sector now climbing higher than in consumer goods, the Fed has a better hand, Friedman said: "Since inflation in the service industry is driven primarily by the labor market, the Fed firmly believes that it can get it under control by tightening monetary policy."
Sharp rise in cyclically sensitive inflation
Cyclically sensitive inflation, which tracks the inflation of all those goods and services whose prices depend on the current business cycle, rose sharply in recent months. Around 40% to 45% of the goods and services consumed in the USA fall into this category. To push it to a level of 2 to 3%, the unemployment rate would have to rise to at least 5%, the economist estimates: "So the Fed will have to bring about a marked slowdown in economic growth to bring inflation back to a sustainable level."
Friedman nevertheless does not assume a deep recession, but rather a moderate one. He expects the Fed to tighten monetary policy too much and the unemployment rate to rise to around 6% as a result, while GDP declines by 0.5 to 1%. The economist draws parallels to the recession of the 1990s, whose subsequent economic recovery was not enough to create new jobs.
"Something similar is likely to happen this time. Maybe there won't be a second 'jobless recovery,' but the recovery is likely to be sluggish. This, as the Fed is unlikely to move to monetary easing even after inflation subsides, lest it produce another flare-up in inflation", Friedman explained.
In the short term, he also expects spreads to widen – for both investment-grade and high-yield credit. In the longer term, however, when the Fed stops raising interest rates and eventually lowers them again, there should be good opportunities in the fixed-income sector.