Economic trends to watch in the second half of 2022

Interest Rates: Hikes are coming

The tight labor market and above-target inflation have set the stage for the Federal Reserve to completely end its pandemic-era monetary support. Policymakers have signaled their willingness to continue raising interest rates in half-point increments – at least at the upcoming summer policy meetings and then incrementally this fall. This would bring the Fed’s interest rates back into neutral territory by the end of the year.

• A neutral interest rate level would mean that monetary policy would neither accelerate nor slow down economic growth.
• Economic expansion is expected to slow to the economy’s underlying potential growth rate of 1¾ to 2 percent when monetary support is removed. But the economy is probably strong enough to continue growing on its own.
• The futures markets are pricing in a steep rise in interest rates. Eurodollar futures and Treasury yields have revived their pre-pandemic highs.

It’s common to hear concerns that persistent inflation will force the Fed to raise interest rates well above neutral territory. But fears that the Fed is heading towards tighter monetary policy are premature.

• Inflation is driven by restrictions in the supply of essential goods. Higher interest rates will do little to boost the supply of goods, which should return to normal later this year.
• A rise in the cost of borrowing above neutral territory would likely cause consumers and businesses to scale back purchases and capital spending.
• This scenario would include prices, but it could also plunge the economy into recession and send unemployment skyrocketing.
• If price pressures ease over the next year, as expected, the Fed is likely to keep rates near their natural equilibrium of 2-3%. Policy makers forecast that interest rates will not exceed 3% for years to come.
• Neutral interest rates could accompany a period of sustained growth, stable prices and low unemployment.
• Stable long-term inflation expectations from bond investors and professional forecasters will reassure the Fed once it exits its accommodative policy later this year.

Real estate: Residential construction could feel the pinch

The housing market is particularly sensitive to rising interest rates since most home purchases are financed with long-term mortgages. Higher borrowing costs could erase some of the surge in home prices during the pandemic era, which was largely due to historically low mortgage rates.

• Mortgage rates are already up two percentage points from their pandemic lows, reducing the purchasing power of potential homeowners by around 22%.
• As home ownership becomes more expensive, institutional investors may seize the opportunity to develop more rental housing.
• A drop in prices must not slow down housing construction, because the nationwide housing stock is still so badly undersupplied.

Trade: Supply chains can face countercurrents

Inflationary pressures are likely to ease in the second half of the year as supply chains return to normal, despite Fed tightening.

The supply chain bottlenecks that have been driving up prices are finally beginning to ease. Price pressures were concentrated on durable goods, particularly automobiles and electronics. However, geopolitical events overseas can complicate the flow of goods.

• China’s recent COVID-19-related shutdowns could lead to new disruptions to global flows of goods.
• Commodity markets are also being rocked by the ongoing war in Ukraine. Energy markets are particularly turbulent as war diverts global supplies.
• These disruptions have resulted in growth forecasts for the eurozone and China being downgraded.

Currency: The dollar should remain strong

The Fed’s tightening comes ahead of similar moves by other countries’ central banks – sending the dollar higher.

• The Bank of Japan is still looking to keep 10-year JGB yields low to stimulate the domestic economy.
• The European Central Bank has been reluctant to tighten monetary policy given the economic disruption caused by the war in Ukraine.
• The Bank of China maintains accommodative monetary policy as the nation faces a wave of COVID-19 lockdowns.

This discrepancy has boosted the dollar’s trade-weighted value against foreign currencies by 10%. Dollar strength is pushing down the cost of imported goods, which could lower inflation by a full percentage point in the second half.

Markets: Rising interest rates and geopolitical risks

Stocks have fallen from record valuations as interest rates rise, but the market should stabilize as price pressures ease and the Fed moves closer to a more neutral stance. The market’s losses also likely reflect fears of further economic dislocation from the war in Ukraine.

• Investors have always understood that interest rates would eventually rise. The market has now priced in the removal of monetary stimulus.
• At the same time, profits remain at historically high levels, partly due to measures taken during the pandemic that have increased efficiencies.

Something to see

The development of the price pressure will determine how the second half develops. Watch for inflation expectations embedded in bond yields to settle towards the Fed’s 2% target.

The Fed is due to release a new interest rate forecast after its June 15 meeting, showing policymakers’ expectations for the trajectory of rate hikes.

Originally edited by JIM GLASSMAN, HEAD OF ECONOMIST, COMMERCIAL BANKING AND GINGER CHAMBLESS, HEAD OF RESEARCH, COMMERCIAL BANKING