Source: Xuetao Macro Notes
Author: Song Xuetao
Since December last year, the Fed has continued to raise interest rates ahead of schedule. The core reason is that inflation in the United States has been rising since November last year, and the CPI has been above 5% for five consecutive months. In March, the CPI was 8.5% and the PPI was 11.2%, both at historical highs.
Controlling inflation is the core task of the Fed without any hesitation. Especially in the election year, there is a strong political motivation to suppress inflation, and dovish Fed officials have also turned hawks.
Therefore, since December last year, the Federal Reserve has been raising interest rates ahead of schedule and shrinking its balance sheet expectations. While the economy and the market can still bear it, it has put bad words to the front and used hawkish signals to suppress inflation expectations as much as possible.
Hawkish expectations have reached the extreme. According to the market expectation of raising interest rates to 2.50-2.75% this year, we use the FRB/US model to estimate that the impact of interest rate hikes on US GDP growth will be close to 1 point. Coupled with the reduction of the balance sheet of 1.1 trillion US dollars, the US economy will emerge “Hard Landing”.
This is the first stage of interest rate hike expectations. In the early stage of tightening, hawkish expectations are often too strong. As a result, the market overreacted and U.S. bond interest rates overshooted.
So at some point the Fed needs to change its attitude to raising interest rates. The basis for the change is that inflation data has fallen year-on-year, followed by signs of recession in economic data.
Rate hike expectations have passed the most hawkish time. Although a one-time rate hike of 50bp in May was the first time since May 2000, Powell basically dispelled the possibility of a one-time rate hike of 75bp at the press conference, and the scale of the reduction of the balance sheet gradually increased from $47.5 billion to $95 billion dollars, not one step.
Recent inflation figures are easing marginally, and the odds of another-than-expected Fed tightening are diminishing. In March, the year-on-year growth rate of core PCE in the United States fell by 0.1% compared with February. The earlier announced core CPI in March rose by 0.1% compared with February, but the growth rate also narrowed significantly. The core CPI fell for three consecutive months.
Core inflation reflects the actual disposable income of residents. Core inflation, especially the weak price of core consumer goods, reflects that high oil prices are eroding the actual spending power of residents.
We estimate that for every US$20/barrel increase in oil price, the growth rate of real disposable income will decrease by about 0.66%, the growth rate of real consumption excluding food and energy will decrease by 1.04%, and the growth rate of real GDP will decrease by 0.94%.
The main contribution from the non-core inflation component came from higher crude oil prices. The price of crude oil has fallen by about $30 recently from a peak of $130 in early March. Although it cannot be ruled out that prices will rise again during the peak demand season in July-August, the crude oil market has basically priced in the Russian-Ukrainian war.
On the supply side, Germany has clarified the timetable for the Russian oil import ban, but some European countries have clearly considered that they will use the ruble for oil and gas transactions with Russia, and the supply premium brought by the Russian-Ukrainian war has declined.
On the demand side, oil and gas have entered the off-season for energy products, electricity demand in Europe has begun to decline, and the epidemic containment in China’s Yangtze River Delta region has also reduced China’s crude oil consumption demand by about 10%. The pricing logic of crude oil is shifting from stagflation expectations of supply disruptions to recession expectations of weakening demand. Oil prices will still adjust if global demand weakens further.
The U.S. economy has entered an inflection point of marked deceleration. In the first quarter, the annualized rate of GDP turned negative by -1.4%, compared with the previous value of 6.9%, which was the first negative turn after the epidemic in 2020.
The main negative contributors to the slowdown were inventory investment and net exports, followed by government spending. Although household consumption and corporate capital expenditure are relatively good in structure, the economy is described as a whole. The decline in inventory investment reflects that high oil prices are affecting retailers and channels’ expectations for future demand, and the growth rate of net exports has turned negative. It is also the result of high oil prices increasing the trade deficit, and the sharp weakening of fiscal spending’s support for the U.S. economy has been difficult to reverse before this year’s election.
A “soft landing” is the Fed’s best hope, but it’s not realistic. The soft landing of the economy in the two interest rate hike cycles in 1965 and 1984 was to avoid economic recession in the context of fiscal easing, and the 1994-1995 interest rate hike cycle with double monetary and fiscal tightening corresponded to the “blonde hair” in the 1990s. girl” economy.
Compared with that time, the current US economy is facing the triple pressure of weakening fiscal support, inflation eroding household income and consumption, and falling residential and industrial investment. The probability of the economy entering a recession next year is increasing.
If exogenous conditions deteriorate further (too fast rate hikes to shrink balance sheets or higher oil prices for longer than expected), the recession may be brought forward to this year.
Therefore, if the Fed fully fulfills its expectation of raising interest rates, the US economy will likely have a “hard landing” at that time, the recession is gradually approaching, and the tightening policy will face a “dilemma”.
Rate hike expectations are beginning to enter the second phase. The inflection point of inflation easing appeared, the economy began to show signs of deceleration, the tightening expectations fell, and they moved closer to reality. The tightening was implemented but in line with expectations.
In the late stage of interest rate hike, inflation has dropped, the economy has decelerated significantly, and signs of recession have begun to appear. Tightening expectations may turn around and enter the third stage of interest rate hikes. At this time, monetary policy may experience a transition from tightening to loosening, similar to that from the end of 2018 to the beginning of 2019. Half-year policy path.
Rate hikes are expected to slow in Q3. Generally speaking, 3-6 months after the Fed starts the interest rate hike cycle, there will be a so-called “brake on the brakes” to re-evaluate the economic situation and the negative impact of interest rate hikes on the economy, and decide whether to continue rapid interest rate hikes in the next stage. Whether the shrinking table needs to be slowed down.
The timing of the turn, the key is that inflation has dropped significantly year-on-year, followed by seeing signs of economic recession. At present, June-July is the time when the year-on-year growth rate of core inflation will further confirm the inflection point. It may be the inflection point of events such as the Russian-Ukrainian war and the Shanghai epidemic.
This is a critical window period, and if the year-on-year growth rate of inflation falls faster, it may be the time for the Fed to change its attitude.
Q4 may stop raising interest rates. After the 10-year and 3-month U.S. debt inversion since 1985, the probability of economic recession is 60%, and the Fed will not raise interest rates after the inversion.
Historically, rapid rate cuts by the Fed after 10-year and 3-month U.S. debt inversions have been an effective way to avoid recessions. According to the current Fed rate hike expectation of 275bp, the U.S. bond yield will be between 2.33% and 2.58% in the three months by the end of the year, which is close to the long-term U.S. bond interest rate ~2.5% in the three quarters after the rate hike by the FRB/US model. 10 Yields on one-year U.S. Treasuries and three-month U.S. Treasuries will invert.
This means that the Fed needs to stop raising interest rates in Q4 this year, and the safer option is to start cutting interest rates immediately after the inversion to avoid a recession.
According to the historical law of interest rate hike cycles in the past, the time when the Fed stops raising interest rates is generally about a year or more before the start of the economic recession. Therefore, even according to the rate hike mode assumed by the benchmark, the Fed needs to stop raising interest rates in Q4 this year at the latest.
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