In March, US inflation demonstrated a subtle deceleration, retreating from 6% to 5%, indicating a persistent “disinflation” trend. However, the country’s tenacious core inflation, discounting food and energy, continues to prompt the Federal Reserve to escalate interest rates. The proliferation of rate augmentations is eliciting concern among an increasing cadre of economists and Federal Reserve officials, who speculate that the probability of a gentle economic descent may be dwindling.
The American economy’s soaring altitude can be attributed to the Fed’s robust maneuvering through interest rate elevations. Demand for goods and services outstrips the economy’s productive capacity, spurring corporations to capitalize on the opportunity to amplify prices. Consequently, the economy is exhibiting signs of overheating, marked by a constrained labor market and elevated inflation.
In hindsight, the Fed maintained excessively low-interest rates in the aftermath of the coronavirus outbreak. Accommodative monetary policies and fiscal stimuli throughout the pandemic intensified demand for goods and services while supply struggled to match pace. The conflict in Ukraine further exacerbated matters as commodity and energy prices surged, intensifying inflationary pressures.
This confluence of factors has caused the US economy to soar to unsustainable heights, with a taut labor market and persistent core inflation. To curb inflation, the Fed, accountable for maintaining price stability, undertook a series of sharp interest rate hikes last year, attempting to orchestrate a controlled economic descent.
Elevated interest rates impose a higher financial burden on families seeking to purchase homes or undertake renovations. Consequently, the demand for goods and services would be dampened, and inflation would recede. Ideally, the Fed would achieve this without inducing a recession—a delicate operation proving difficult in practice.
The ramifications of interest rate hikes on the economy generally manifest after a year, complicating the task of ascertaining the precise number of hikes required for a smooth landing. Simultaneously, the Fed must avoid appearing overly lenient, as such a perception might incite fears of prolonged high inflation among businesses and households. The mere anticipation of inflation can fuel price increases through elevated wage demands and preemptive price hikes by businesses.
Economists posit that the Fed often elevates interest rates until a rupture materializes. The initial fracture due to stringent monetary policy emerged in the form of a banking crisis following Silicon Valley Bank’s collapse. While the situation appears to be contained for now, apprehension among US regional banks over fleeing savers persists, subsequently hampering their propensity to lend.
ING highlights that, even prior to the banking turmoil, financial institutions had already adopted a more stringent approach to construction lending at the onset of the year. The reticence among US regional banks could carry significant repercussions, as they provide nearly 70% of commercial real estate loans and 40% of family mortgage loans.
Tighter real estate lending and elevated interest rates could potentially trigger a crunch in the sector, subsequently impacting the construction industry and the broader economy. Despite a business survey revealing accelerated economic growth in April, indicators suggest the labor market is exhibiting signs of cooling.
More crucially, the economic outlook has notably worsened. On Thursday, data showed the index of leading indicators had declined for the 12th consecutive month in March. “We forecast a recession commencing in mid-2023,” stated The Conference Board, the research firm responsible for calculating the index.
Considering the pivotal role of mid-sized banks, ING harbors growing concerns about a hard landing for the US economy. Echoing this sentiment, Federal Reserve economists anticipate a “mild recession” later this year, as per their most recent meeting minutes.
Similar concerns have been raised by the International Monetary Fund (IMF), which perceives an increased risk of a hard landing due to unrest in the financial sector. Notably, however, the watchdog maintains the importance of raising interest rates to counter inflation. Should a hard landing indeed transpire as a result of diminished demand for goods and services, inflation is expected to self-correct rapidly.
ING economist James Knightley projects a marked decrease in inflation during the latter half of the year, driven by declining property prices. He also cites the deteriorating financing landscape’s impact on new and used car sales and their prices. Housing and automobile expenses heavily influence the index.
Knightley refers to a March survey of American business owners, which revealed that the proportion of companies contemplating price hikes in the subsequent three months fell to 26%, a significant drop from 52% a year prior. According to Knightley, this figure often serves as an accurate predictor of core inflation. Based on this metric, he anticipates core inflation will subside to below 3% by year’s end, a stark contrast to the current lofty 5.6%.