By Randy Myers
When the Federal Reserve began raising interest rates in 2022, many investors hoped the Fed’s war on inflation could be won without provoking a recession. Steve Friedman, senior macroeconomist with MacKay Shields, an affiliate of New York Life Investments Co., doubts that will happen. While the economy appears relatively strong at the moment, he credited that, in part, to a confluence of factors that have temporarily created a uniquely supportive economic environment.
Speaking at the Stable Value Investment Association’s 2023 Spring Seminar on May 4, Friedman warned that engineering a cyclical slowdown in the economy without tipping it into a full-blown recession—steering it into a “soft landing,” in other words—is difficult when, as now, inflation is high and unemployment low.
“When inflation is high, the Fed just doesn’t have flexibility to respond to any weakness in growth,” Friedman explained. “It has to remain laser-focused on the inflation side of its mandate, and indeed, that’s what we’re seeing.”
Friedman noted that on May 4, when the Fed raised its target for the federal funds rate for the 10th time since March 2022, Fed Chairman Jerome Powell made it clear that getting the annual inflation rate down to 3% (it was 5% in March 2023) would not be good enough. Rather, Powell would like to see inflation fall to Fed’s long-term objective of 2%.
“He (Powell) also was very clear that rate cuts this year were very unlikely,” Friedman said.
Friedman said the Fed was able to engineer a soft landing during a period of high inflation and low unemployment in the 1960s, but that Fed officials largely view that as the exception that proves the rule since it ushered in the extraordinary levels of inflation seen in the 1970s.
Commenting on the economy’s health at the moment, Friedman noted that it usually takes about two years from the first Fed rate hike before it starts to contract. But, he added, there are a lot of sources of resilience in the economy right now that are helping to keep it afloat. Those sources include excess household savings built up during the pandemic, which continue to buttress consumer spending, and low interest rates on consumer and corporate debt that were locked in before the Fed started hiking rates. Above-trend spending on social programs, and a reluctance by businesses to reduce staff amid a tight labor market, also are helping the economy, he said.
Still, “under the surface we are seeing signs already of a slowdown,” Friedman said. He pointed to recent downturns in consumer spending and business activity and a weaker housing market. At a more granular level, he called out a slowdown in core capital goods orders, a recent downtick in corporate profits even though they remain at a high level, an uptick in consumer debt delinquencies, and a downturn in average weekly work hours among production and nonsupervisory workers.
Michael Leonberger, a stable value portfolio manager with Invesco Fixed Income, joined Friedman on the SVIA stage and asked him how the recent failure of First Republic Bank, and concerns about the health of other midsize banks, might impact the economy. Friedman answered that “the good news, if there is good news,” is that the government’s response to the First Republic Bank failure has been very effective, with no insured depositors losing any money. The bad news, he countered, is that depositors may still run from banks with bad business models or poor risk management practices moving forward, which could further pressure the industry.
“Even as we came into this crisis (in the banking sector), bank credit growth had been slowing,” Friedman added. “I expect it will continue to do that. We’re in a phase now where we’re likely to see a contraction in credit available for the economy, and that certainly feeds into our view that a recession is more likely than not.”
If correct in its view that the economy will begin to contract later this year, Friedman said, MacKay Shields would expect corporate credit spreads to begin to widen and that expectations for credit defaults would increase as well. However, he said, the quality of the credit market is high enough today that even if spreads widen and defaults rise the fallout won’t be nearly as bad as it was during the credit crisis of 2008.
Asked at the conclusion of his talk about the implications of the U.S. defaulting on its debt if Congress doesn’t agree to raise the debt ceiling, Friedman said Congress and the White House may reach a short-term agreement to raise the debt ceiling until the end of July, giving them additional time to negotiate a more lasting solution. He cited the need for compromise, but cautioned that he is “skeptical this gets resolved without a lot of market pressure” given that the parties involved have positions that are “untenable to the other side.” “I think Democrats realize that they have to back away from their stand of just a clean increase to the debt ceiling—that they’ll have to make some compromises,” Friedman said. “There need to be some spending cuts. The issue is there’s nothing left to cut other than things that people really like. So you’d have to be willing to cut military spending or social programs, and both of those have significant support. I think you will get a resolution (to raise the debt ceiling), but I think the economic consequences will be less than they were in 2011, when Washington reached a deal to put some significant spending caps in place. I just don’t know if I see the appetite for that right now. That tells me that any deal will likely have a very moderate effect on the economy in terms of fiscal contraction.”
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