Will the Fed's approach to interest-rate hikes trigger a U.S. recession?

The U.S. Federal Reserve has hinted strongly that May 4’s 50 basis point interest-rate hike is merely the beginning of what’s to come. Is the U.S. central bank so determined to eliminate inflation that it’s willing to risk recession?

The U.S. Federal Reserve’s (Fed’s) recent decision to raise interest rates surprised no one; neither did its announcement confirming that quantitative tightening will begin June 1. After all, one of the Fed’s mandates is to quell inflation and, by all accounts, the U.S. economy is running a little too hot.

There are, however, two key considerations that we’d like to highlight:

  1. Interest-rate hikes won’t lower food and energy prices—these prices remain a function of the Russia-Ukraine conflict and COVID-19-related distortions. As such, the Fed will have to create deflationary pressure in parts of the economy that it can influence, in areas such as general merchandise, to quash inflation. In such a scenario, we may find ourselves in a peculiar situation where we see declines in the prices of interest-rate-sensitive goods and services (housing being the key exception here) while energy and food prices remain elevated.
  2. In a departure from historical norms, the Fed is embarking on a rate-hike cycle as the economy heads into a soft patch. In our view, an overly aggressive approach to hiking rates (both in terms of pace and magnitude) will bring about the worst of both worlds, leaving consumers with the kind of inflation that hurts their disposable income the most (groceries and gas) while stunting growth. 

Inflation concerns reign supreme (over growth)

The Fed has usually taken a balanced approach to achieving its dual mandate of maintaining price stability and full employment. This delicate balance, however, seems to be heavily tipped toward inflation at the moment and at the expense of growth. 

This can be seen in the most recent FOMC statement, where the rate-setting committee downplayed Q1’s negative GDP reading, opting instead to emphasize the strength of household spending and business investment. We think that’s a mistake—the impact of falling U.S. fiscal spending (a function of the end of pandemic-related spending) has yet to be fully realized, and demand for U.S. exports is likely to weaken as global growth stalls. 

U.S. GDP contracts in Q1 2022 (%)
Chart of quarterly U.S. GDP from first quarter 2019 to first quarter 2022. The chart shows that U.S. GDP contracted in the first quarter of 2022, with net exports being the biggest drag on growth.

Source: U.S. Bureau of Economic Analysis, Manulife Investment Management, as of May 10, 2022. The gray area represents a period of recession.

This is also evident in the way the statement referenced how COVID-19-related lockdowns in China might lead to further supply chain disruptions and exacerbate price pressures but remained silent on how these developments could hurt global growth and affect aggregate demand. This tells us that the Fed is almost wholly concerned about inflation and much less worried about growth.

However, while it’s true that the U.S. jobs market remains tight, several leading economic indicators we’re tracking suggest that the momentum could slow in the next few months. Crucially, we believe the Fed will have to shift some of its focus back toward jobs as labor market data appears to soften.

The U.S. labor market remains robust (%)
Chart comparing U.S. unemployment rate with U.S. underemployment rate from May 1982 to data available as May 10, 2022. The chart shows that both unemployment and underemployment are now at  prepandemic levels.

Source: U.S. Bureau of Labor Statistics (BLS), Manulife Investment Management, as of May 10, 2022. BLS defines underemployment (U6) as all persons who are unemployed, plus those who are marginally attached to the labor force and who are working part time for economic reasons, expressed as a percent of the civilian labor force plus those who are marginally attached to the labor force. The gray areas represent periods of recession.

Caught between two fires: inflation vs. recession

Here’s a question that’s on everyone’s mind: How far will the Fed go? Is it willing to push the U.S. economy into recession in its quest to put the inflation genie back into the bottle? Up until a month ago, we believed that the Fed would do everything it can to avoid such a scenario, but recent Fed communication suggests (to us, at least) that the central bank would rather create a recession in the short term than risk entrenched inflation.

In our view, Fed Chair Jerome Powell’s comments at the May 4 FOMC press conference were rather telling: While noting that the Fed had a good chance of restoring price stability without causing an economic contraction, he repeated his admiration for former Fed Chair Paul Volker, who famously pushed interest rates to 20% to tamp down inflation in 1981. Reading between the lines, Chair Powell appears to be signaling that he isn’t too concerned about the need to avoid a recession. This idea seems to be supported by Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, whose latest blog post dated May 6 (which he also reiterated at a speaking event) has been widely interpreted as an admission that the Fed may have to nudge the economy into recession if price pressures don’t ease soon. 

Our base case is that a technical recession will be avoided ...

Does this mean that the U.S. economy will slip into recession? Our base case is that a technical recession will be avoided; however, our forecast is predicated on the expectation that the Fed will only raise interest rates by another 100 basis points (bps) in 2022. If the Fed were to hike rates by much more than that, it’d be a different story. We continue to expect the Fed to make a dovish pivot when evidence of U.S. economic weakness mounts. And perhaps more importantly, we think the focus on whether there’ll be a recession is less important to markets than the very real threat of a material economic slowdown. 

Will the Fed lose its hawkishness? Factors to watch

Based on what was communicated at the press conference on May 4, it’s fair to say that Mr. Powell has already indirectly laid out the conditions that could convince the Fed to consider making a dovish pivot—key among them: More evidence that inflation in the United States has either reached a peak or is in the process of flattening. According to the Fed chair, a return to 25bps interest-rate hikes (as opposed to 50bps hikes) at upcoming FOMC meetings could be possible at that point. Another condition that Mr. Powell mentioned was the need for long-term inflation expectations to remain well anchored.

The U.S. economy is already displaying signs of slowing

Small Business Optimism Index

Chart of the U.S. National Federation of Independent Business’ Small Business Optimism Index from May 2007 to data available as of May 10, 2022. The chart shows that business confidence among small businesses has fallen in recent months.

     (%)

Chart of U.S. existing home sales from May 1990 to data available as of May 10, 2022. The data shows that U.S. existing home sales has fallen significantly in recent months.
Source: National Federation of Independent Business (NFIB), National Association of Realtors, Macrobond, Manulife Investment Management, as of May 10, 2022. The gray areas represent periods of recession.

In light of the current macro backdrop, we believe the Fed could reach that moment in the summer. For what it’s worth, the U.S. economy is already displaying signs of a slowdown:

  • Business surveys peaked last November and leading macro indicators such as Purchasing Managers’ Indexes (PMIs) are on track to return to neutral territory or lower later this year
  • Housing activity is cooling—new home sales fell for the third straight month in March, coming in below expectations
  • The inventory overhang in the non-autos space is sizable and isn’t likely to be a key contributor to growth in the coming quarters
  • March consumer spending rose only 0.2% from the previous month, which is weaker than expected
  • Monthly data on wage gains may seem impressive but hasn’t kept pace with inflation; in other words, real wage growth is negative

The growth picture outside of the United States doesn’t inspire much optimism either: Slowing growth in China remains a worry—recent PMI readings point to a contraction and official stimulus may be insufficient to offset continuing weakness, particularly in view of the government’s COVID-zero policy. The situation in Europe isn’t any better; in fact, the currency bloc could be headed toward a recession: Italy’s economy contracted in Q1 as France’s economy flatlined. Crucially, Germany’s growth prospects have been severely dented by the conflict in Ukraine due to its dependence on Russian energy.

Against this backdrop, we continue to believe that the Fed is likely to make a dovish pivot in the next few months as evidence of an economic slowdown mounts.

Clues from the Bank of England: the canary in the coal mine?

While everyone was focused on the Fed, we think it’s just as important to pay attention to the Bank of England (BoE). The BoE embarked on its rate-hike cycle last December, becoming the first major central bank among developed markets to do so. In other words, the U.K. central bank’s monetary tightening journey precedes the Fed by six months and its actions could provide insight in regard to the FOMC’s decisions going forward.

As we understand it, the BoE’s messaging suggests that central banks are likely to be willing to spur recessions if necessary.

On May 5, the BoE delivered its fourth interest-rate hike in six months, raising rates by 25bps (against expectations of a 50bps hike). What’s particularly striking is that the BoE had embedded negative GDP growth into its forecast. Essentially, the central bank has all but confirmed that it will knowingly hike into an economic contraction/recession in its quest to tamp down inflation.

As we understand it, the BoE’s messaging suggests that central banks are likely to be willing to spur recessions if necessary, and that when they do make a dovish pivot, these pivots are likely to come in the form of smaller rate hikes as opposed to no hikes, initially, at least—as Mr. Powell seemed to be saying at the press conference on May 4.

Given that Fed is still very much in its hawkish phase, other global central banks are likely to pivot first (possibly the Bank of Canada, as Canadian housing data weakens), which also means that U.S. dollar strength will likely continue in the near term. Note that a stronger greenback has important implications for a variety of asset classes and is ultimately deflationary for the U.S. economy.

A Fed pivot remains likely

All things considered, despite recent hawkishness, we have high conviction in our belief that soft economic data will force the Fed to change course; however, the path there is likely to be bumpy, characterized by bouts of volatility that we have seen in the past few months. While markets will continue to focus on whether there will be a recession, we continue to emphasize that what really matters is the likelihood of a material growth slowdown in the United States and the global economy. 

A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other pre-existing political, social and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.

Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments.  These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.

The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.

This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management or its affiliates. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.

Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice.  This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.

Manulife Investment Management

Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.

This material has not been reviewed by, is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional

Australia: Manulife Investment Management Timberland and Agriculture (Australasia) Pty Ltd, Manulife Investment Management (Hong Kong) Limited. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad  200801033087 (834424-U) Philippines: Manulife Investment Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United Kingdom: Manulife Investment Management (Europe) Ltdwhich is authorised and regulated by the Financial Conduct Authority United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC and Manulife Investment Management Timberland and Agriculture Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.

Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.

553611

Frances Donald

Frances Donald, 

Global Chief Economist and Strategist, Multi-Asset Solutions Team

Manulife Investment Management

Read bio