Have a Soft Landing*

*Editor’s note: On March 4, Russia enacted a law that criminalizes public opposition to, or independent news reporting about, the war in Ukraine. The law makes it a crime to call the war a “war” rather than a “special military operation” on social media or in a news article or broadcast. The law is understood to penalize any language that “discredits” Russia’s use of its military in Ukraine, calls for sanctions or protests Russia’s invasion of Ukraine. It punishes anyone found to spread “false information” about the invasion with up to 15 years in prison.

Analyst Mikhail Denislamov on the largest key interest rate increase by the U.S. Federal Reserve since 1994.

Following its latest meeting, the Federal Reserve raised the key interest rate by 75 basis points. Meanwhile, previously announced plans to reduce the size of the balance sheet remained unchanged. The Fed’s benchmark short-term rate is now pegged at a range of 1.5% to 1.75%. Such a dramatic move, not utilized since 1994, seems justified given current macroeconomic conditions. The decision was taken almost unanimously. Only Esther L. George, chief executive of the Kansas City Federal Reserve Bank, disagreed, voting to raise the rate by 50 basis points.

A week earlier, that scenario seemed unrealistic, and market participants expected the interest rate to be raised by 50 basis points. But all that changed on Friday, June 10, when it transpired that the U.S. consumer price index unexpectedly set a new record high in May, demonstrating year-on-year growth of 8.6%. For the month, the index increased by 1% against an expected 0.7%. Moreover, as Fed Chairman Jerome Powell said at a press conference, the latest data from the University of Michigan was an important argument in support of a sharp interest rate hike. Researchers pointed to an unexpected jump in long-term consumer inflation expectations. While in the previous few months, consumers had been expecting a 3% inflation rate over the next five years, the figure jumped to 3.3% in early June, the highest since 2008.

The sharp interest rate hike was primarily intended to anchor inflation expectations again by showing consumers a determination to fight inflation. The Fed has revised expectations for the trend of the key interest rate hikes for the same reason. Officials believe it is appropriate to raise the key interest rate to a value in the 3.25% to 3.5% range by December 2022, which is 150 basis points higher than the March forecast. The Fed has indicated that the rate will peak at 3.75% to 4% in 2023 and could start to decline as early as 2024.

The Fed also updated its macroeconomic forecasts. Real gross domestic product growth expectations have been markedly lowered from the March estimates — the 2022 GDP forecast decreased from 2.8% to 1.7%, and the 2023 figure from 2.2% to 1.7%. Combined with the projected increase in the unemployment rate from the current 3.6% to 4.1% in 2024, these are negative aspects of the Fed report. Still, they fit within the definition of a more or less “soft landing” for the economy that Powell often talked about.

Inflation forecasts were raised mainly because of rising energy and food prices. In 2022, the Fed now expects the core personal consumption expenditures price index to increase by 4.3% rather than 4.1%. Additionally, the overall PCE price index could rise by 5.2%, well above the March estimate of 4.3%. Inflation projections for 2023-24 are virtually unchanged, likely reflecting the expected effects of high interest rates on demand and the Fed’s hope for further improvement in supply chains. According to officials, inflation will still exceed the 2% target for the foreseeable future. However, monetary policy will become accommodative in 2023-24, with the Fed’s rate exceeding the PCE inflation by nearly 1%. You could say that the updated macroeconomic forecasts now better reflect both the necessary interest rate hike and the moderately negative impact of a constrained monetary policy on the economy.

With inflation remaining high in June due to higher gasoline and services prices, investors should brace for another 75-basis-point hike at the July meeting. This will allow the Fed to reduce the key interest rate to a neutral long-term level in the 2.25% to 2.5% range as soon as possible. Most likely, after that, the interest rate hikes will start to decline — the Fed will need to act with more restraint. It is unlikely that the key interest rate will exceed 3.5% in 2023 — a decrease in real consumer spending could serve as a serious constraint and a factor in a more rapid decline in inflation.

The Fed has been very flexible this time, reiterating its willingness to act based on incoming macroeconomic data. However, it should be understood that this flexibility is forced. The economy is beginning to look increasingly vulnerable, and one wrong action could potentially plunge the country into stagflation or recession. Indeed, there is still a chance for a soft landing. Still, the path to that benign scenario is becoming more complex, making investors in the stock market nervous. The Standard & Poor’s 500 index initially responded with a moderate rise of 1.46% by the end of the trading session. But that increase was more of a technical rebound from the low marks than an attempt to reverse the downtrend. The yield on a 10-year Treasury note, currently hovering around 3.4%, will continue to move into the 3.5% to 4% range. In that range, a maximum value for the current key interest rate hike cycle will likely be formed. While the Treasury note yields rise, the stock market will remain under pressure.

The author is a senior analyst at Freedom Finance Investment Company. The author’s opinion may not necessarily reflect the views of Izvestia’s editorial board.