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Q2 2022 Growth collapse virtually assured

The Fed may be as wrong on growth now as it was on inflation last year

“The economy is very strong. In my view the probability of a recession within the next year is not particularly elevated.”

Jerome Powell, March 16, 2022

The global credit impulse downturn, shown before, corroborates with the latest global data going into February suggesting that the world economy was already in a downtrend before events in Ukraine.

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https://twitter.com/BittelJulien/status/1504736611799650304

The chart below shows the OECD estimate of the economic impact of developments in Ukraine for the next one year time horizon. Clearly this is a shock in favor of higher inflation and lower growth in the near term.

Even before these Ukraine economic impacts, Hedgeye were already seeing quarterly GDP growth for Q1 2022 below 1% from 7% the prior quarter. A sizeable drop. In the US, Q2 2022 was already expected to be a deep Quad 4 (declining growth and inflation) economic environment, which is the most challenging conditions for most asset classes.

It is in this context that the Fed has started to raise interest rates, which will slow growth even more. Now the Fed is finally reacting to the inflation breakout it missed last year, and the Fed believes the economy is “very strong” so they don’t see much risk to the economy in raising interest rates. Furthermore, the Fed intends further tightening for the rest of the current year, and into next year.

The Fed is Ignoring Clear Signals

The Fed is not only out of line with the most accurate forcasters, it is also ignoring the clear signals from the Treasury bond market. Immediately on the Fed’s announcement of raising rates the yield curve flattened even further. This is the bond market’s way of signaling growth slowing down the road. The yield curve has been flattening for over a year already.

The chart below shows the yield curve is already flat between 3 and 10 years. It is even flatter than the last time the Fed CUT rates at the end of 2018. The bond market is clearly signalling weak growth or even a recession down the road.

The Fed is far more optimistic about the enduring strength of the economy, as you can see from their latest forecast table below. Even with interest rates rising to around 3% next year they see no resulting economic weakness. Yet, at the same time inflation still glides back towards their 2% target. This looks like wishful thinking rather than a realistic trade off between both growth and inflation subsiding.

The 3% interest rate target also looks ambitious given an already flat curve at 0.5% interest rates.

While higher rates make sense to curb inflation, it seems challenging to raise interest rates as far as 3% in a slowing economy with an already flat yield curve. So the Fed may drive interest rates higher into a growth slowdown, they have decided not to forecast.

The markets may short cut their plan.

Long Term Equilibrium Interest Rates

Perhaps the most revealing part of their forecast is that their estimate of the long term equilibrium interest rate has fallen to a new low rate. This is a remarkably low rate as it equates, somewhat, to expected long term nominal GDP, which is the sum of growth and inflation, and suggests very weak long term growth on a 2% inflation rate

This means that despite the Fed’s short term economic confidence their long term projection is for even lower long term economic growth. Go figure.

In Summary

The Fed’s forecasts seem inconsistent in multiple ways. The Fed is planning to tighten policy to around 3% over the next two years, which is a rate above the peak of the 2018 interest rate cycle. This also ignores any new burden from the record debt issuance over the last 2 years, and from an unwinding of the policy excesses of the last 2 years.

This tightening will, apparently reduce inflation but not growth.

Their forecasts are a radical departure from the most accurate private sector estimates, and also the Treasury bond market.

Their strong near term growth forecast is clearly inconsistent with the lower long term equilibrium interest rate.

The Fed is on a collision course with market forces, as they are very unlikely to be able to complete the plan they have set out in this forecast. Their plan will reinforce the current decline in growth and may not even last beyond the growth collapse of the coming quarter.

Best Practice is a matter of your Best Interest.


Education and a Commitment to Informed Consent is an Obligation.

Chris Belchamber is an IRMAA Certified Planner

Medicare’s IRMAA impacts every retirement plan. Learning how to mitigate it is available via IRMAA Certified Planners designation.

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