'Worst Fears Confirmed' As Fed 'Plays Dangerous Game' With Inflation And Rate Hikes

Topline

With the Federal Reserve embarking on its most aggressive tightening campaign in nearly three decades, Bank of America economists warned clients on Friday that the central bank’s inflation-fighting measures will increasingly risk a recession next year—joining a wave of experts voicing concerns about the implications of higher interest rates, which help fight inflation at the expense of economic growth.

Fed Chairman Jerome Powell testifies during his re-nomination hearing before the Senate Banking, … [+] Housing and Urban Affairs Committee.

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Key Facts

“Our worst fears around the Fed have been confirmed,” Bank of America economists led by Ethan Harris wrote in a Friday note, cautioning that officials are “playing a dangerous game of catch up” after instituting a rate hike of 75 basis points on Wednesday, the largest in 28 years.

Though inflation has been surging at the quickest pace in about four decades since November, the Fed only started raising rates in March—thereby risking a “boom and bust” outcome for the economy, says Harris.

The analysts say the most likely outlook is now “very weak” growth as the delayed impact of tighter financial conditions cools the economy, with persistently high inflation that settles at about 3%, compared to the historical standard of 2%, and gross-domestic-product gains fading to nearly zero by the second half of next year.

As a result of already waning consumption, Bank of America slashed its growth outlook for this year to 1.5% this quarter from 2.5%, and said there’s a 40% chance a recession, characterized by two consecutive quarters of negative GDP growth, starts next year—higher than the 33% odds the economists issued late last month.

On the bright side, Harris said that any recession will likely be mild given that it’s easier for the Fed to manage a sharp slowdown if Fed policy is causing the weakness—a sentiment shared by Morgan Stanley CEO James Gorman earlier this week, when he warned of a “bumpy ride” ahead for investors and put the odds of a recession at 50%.

Others are more optimistic: In a recent note, LPL Financial analysts said the odds of a recession are likely closer to 33%, if not lower, given that corporate earnings are healthy and inflation pressures are likely to ease, even if the “process to get there isn’t smooth for markets.”

Crucial Quote

“In a strange way, the year so far has been a painful return to normal… The Fed is no longer willing to step into the breach to support growth or equity prices,” David Donabedian, chief investment officer of $98 billion CIBC Private Wealth U.S., said in emailed comments, on Friday. “By raising rates 75 basis points, the Fed has signaled it is willing to accept a recession to get inflation under control.”

Chief Critic

_{“We don’t believe the Fed can stop the issues that are causing inflation on the supply side without absolutely wrecking the economy, but at this point, it looks like they are resigned to the fact that it must be done,” says Brett Ewing, chief market strategist of First Franklin Financial Services, pointing out Wednesday’s Fed decision marked the first rate hike during a bear market.}

Key Background

The Fed’s withdrawal of pandemic stimulus measures has hit stocks hard this year—and sparked growing fears of a recession. Uncertainty has come to a head in recent weeks, with all major stock indexes plunging into bear market territory on Monday, and a wave of layoffs impacting several recently booming technology and real estate companies. To make matters worse, the U.S. economy unexpectedly shrank 1.4% last quarter. “Recession risks are high—uncomfortably high—and rising,” Mark Zandi, chief economist at Moody’s Analytics, said in a recent note. “For the economy to navigate through without suffering a downturn, we need some very deft policymaking from the Fed and a bit of luck.”

Big Number

8.6%. That’s how quickly consumer prices rose in the 12 months ending in May, unexpectedly returning to the highest level since 1981.

‘Worst Fears Confirmed’ As Fed ‘Plays Dangerous Game’ With Inflation And Rate Hikes