The Fed’s clear path

Roger Aliaga-Díaz: At midyear 2023, we’re tracking closely with the scenario we set forth early this year. Inflation peaked in 2022 in the U.S. but reducing price pressures tied to the strength in the labor markets and wage growth would take longer.

We anticipated that the Fed would not achieve inflation targets before 2024 and that the Fed would actually need to continue their aggressive tightening cycle into 2023 before pausing.

We also anticipated that the Fed would be reluctant to cut rates this year given the need to cool down wage growth.

Based on all this, we saw a strong likelihood of a recession in the United States this year.

As of today, economic indicators still suggest that a Fed-induced recession is very likely.

In fact, we believe the Federal Reserve has still a bit more work to do to bend the inflation curve and ensure that inflation is heading towards the right level, the target level of 2%. We still maintain the Fed should not start cutting rates anytime soon, certainly not this year.

Unfortunately, the Fed still has no choice. Not raising interest rates high enough and keeping them there long enough would open the door for runaway inflation, and that eventually would lead to greater job losses and a deeper recession than the one we expect.

With the significant risks that we saw earlier this year in terms of banking-sector stress and the debt ceiling debate and potential default on U.S. government debt, with those risks apparently behind us, the Fed path is now clear.

Yet, a few things have surprised us. For one, the strength of the labor market: We would have thought that by now we would be seeing some cracks in the labor market. But job growth remains strong, and the unemployment rate continues to hover around historical low levels below 4%. The U.S. consumer also has remained incredibly resilient throughout the tightening cycle.

So, whether a recession is declared later this year or in 2024 is really a matter of timing. We do expect growth to slow, and we expect the unemployment rate to start rising. The job gains that are slowing will actually turn into outright job losses at some point, unfortunately. And this is just a function of the Fed rate hikes doing what they’re intended to do.

Why haven’t rate hikes already resulted in a broader slowdown in the economy? Part of the answer is that it takes time for monetary policy to work its way through the economy.

But also, we believe the neutral rate may be higher than what we’d think. The neutral rate is the theoretical rate that reflects an economy in balance. If that's true, the Fed may need to raise rates to 6% or even higher to beat back inflation and finish the job.