Economic Market Analysis
High interest rates threaten the outlook
In the wake of significant interest rate increases, the economic outlook includes high uncertainty. This is true across economies globally, but it is especially true in the United States, where the Fed has worked hard raising rates to dampen inflationary pressures, some of which have been sticky and stubbornly high. The risk of persistent, elevated inflation is the Fed’s top priority because U.S. government and consumer debt are at record alltime highs. Financing over $30 trillion in government debt is expensive. If high inflation is perceived to be permanent, long-term interest rates could remain elevated, greatly increasing the interest expense to refinance outstanding debt. Such a cascading set of effects would risk reducing potential growth output across the entire economy.
Despite significant interest rate increases, the timeline to get inflation back down to the Fed’s 2% target has been repeatedly pushed further into the future. The delayed abatement of inflationary pressures has prompted the Fed and other central banks to continue tightening monetary policy to a level that has increased downside economic risks.
So, what will the Fed do next? Market participants and economists are struggling to price in the Fed’s next course of action. Some expect rate cuts will come soon, while others look at elevated inflation rates and wonder if the Fed might need to keep rates high and unchanged for a significant period of time. Even a few observers wonder if the Fed may even seek to restrict monetary accommodation further.
Rather than necessitating additional Fed rate hikes, we believe the most significant factor that could weigh on year-on-year inflation rates is time to let previous Fed monetary tightening do its job. After all, it is widely accepted that Fed policy actions have lagged impacts. But investors, policymakers and market mavens are an impatient lot. The Fed has some ability to wait and assess the lagged effects of its restrictive policies, but it does not have much time.
Jobs are the license for monetary tightness
Whenever the Fed sets policy, inflation and employment data are the primary factors impacting Federal Open Market Committee (FOMC) decisions. Inflation is elevated, which is why it has been the top concern and focus of Fed policy over the past 18 months. Meanwhile, the U.S. labor market has been relatively resilient, despite many layoff announcements in six consecutive quarters since early 2022.
If jobs data remain relatively positive, the Fed will likely have the license to keep monetary policy relatively tight to chip away at inflation until rates approach the Fed’s 2% target. But, as Fed members are so wont to remind us, the Fed will likely remain “data dependent” when assessing its future course of action.
On the upside, solid jobs data don’t just give the Fed license to raise rates. The relative strength of U.S. jobs and the labor market are also vital in supporting GDP growth and preventing a deep U.S. recession. There are significant downside risks from high interest rates for corporate earnings and fixed investment, but jobs are a lynchpin for overall consumption in the U.S. economy. And people with jobs most certainly engage in consumption.
This is why the Fed, policymakers, investors and economists watch U.S. jobs data so closely. If U.S. employment data remain strong, it may be enough to keep a significant recession at bay.