At its June 14-15 meeting, the Federal Reserve decided to hike its Fed Funds Rate by 75 basis points, the largest single hike since 1994, to 1.5-1.75% in order to tame inflation.
In addition, the Fed downgraded its economic growth projection and raised unemployment and inflation rate projections significantly, hinting there will be a substantial hikes to tame continued inflation.
We believe the 75 bps hike and further substantial hikes will create a ripple effect worldwide and cause financial crisis and/or recession in the US, Europe and emerging markets. The magnitude depends on the level of inflation and the monetary policy tightening to tame that inflation.
To compare the current stage of stagflation with the 1970s era, we studied the development of the US consumer price index in 1970s. The combination of 1) an oil shock, 2) dirty politics, and 3) a weak central bank led to the first wave of high inflation. The Fed had to hike rates to near the rate of inflation, after which the economy collapsed.
We found:
The current US government has not intervened with the central bank as aggressively as it did in the 1970s (the Nixon era);
The US government is trying to solve the supply-side problems, especially increasing oil production capacity; and
The Fed remains focused on fighting inflation. Unlike in the early stages of the stagflation crisis in the 1970s, the authorities emphasised accommodative monetary policy, which creates inflationary pressures.
We conclude inflation is unlikely to reach the same peak (12-14%) as in the 1970s.
The inflation expansion makes us believe the US policy interest rate will peak at around 3-4% in the first quarter of next year and thereafter. By mid-2024, the US economy is likely to enter a recession.
We believe eurozone economic growth will fall into recession in the second half of 2022 for three reasons: 1) it is at the epicentre of the conflict between Russia and Ukraine, which is becoming lengthy; 2) sensitivity analysis shows that Europe is prone to both GDP downgrades and an inflation spiral; 3) the European Central Bank (ECB) is way behind the curve, while the rising bond yield, especially in peripherals, led the ECB to implement the “anti-fragmentation” mechanism, which will lead to vulnerability in Europe’s financial system.
For China, the world’s second-largest economy had a mixed recovery in May as Covid restrictions gradually eased, with industrial production unexpectedly increasing, while consumer spending and the property market continued to contract to a lesser extent.
This implies growth has bottomed out and the recovery has just started.
Some Covid restrictions in Shanghai were eased in May, allowing factories to gradually resume production and logistics bottlenecks to ease. However, stringent controls continued to hinder consumer activity across the country.
The course of the recovery remains uncertain as Beijing continues to rely on lockdowns and other restrictions to contain large-scale outbreaks of the virus. We believe the government will continue this policy until President Xi Jinping is sworn in for a third term in November, with continuing risk of lockdowns hurting the economy.
Chinese authorities have begun to signal easing of monetary and fiscal policy, such as the reduction of the reserve requirement ratio and the issuance of 23 measures to relax liquidity tightening, along with 33 fiscal measures to stimulate the economy.
The authority is also allowing the yuan to depreciate, which we believe will lessen the impact and keep GDP growth this year within 4%.
With this backdrop in mind, our global macro model suggests the eurozone is increasingly at risk of a recession this year, with GDP contracting in the second half and into the first quarter of next year due to the weaknesses mentioned above.
Economic growth in other countries will deteriorate, but not fall into recession this year or next.
In terms of inflation, we raised our projection significantly, with the peak of the current cycle pushing into the third quarter, especially in the US, eurozone and Thailand. Subsequently, the increasingly high base effect of oil prices and the impact of front-loaded monetary policy tightness will lead to declining inflation in the fourth quarter this year and in 2023.
In terms of monetary policy, we believe the Fed will be the most hawkish central bank in our study. We expect another 175 bps hike from now until the end of the year, while the path is front-loaded.
The ECB will hike 175 bps from now, but off a lower base than in the US, with the ECB deposit rate roughly 1.25% at year-end. China’s central bank may nudge its rate down 10 bps, while the Bank of Thailand will hike roughly 50 bps from now until year-end.
An economic downturn, financial volatility and persistent inflation are the results from the Fed’s too little, too late interest rate hikes in the first half.