Aggressive Fed increases risk of policy error: Clearbridge

As quickly as the world came out of the pandemic, it was faced with yet another black swan event that caused markets to capitulate, and left supply chains in disarray.

With the US Federal Reserve’s faster tightening than many had expected, it has increased the risk of recession and policy error, making a hard landing more likely than a soft landing. Clearbridge Investment Portfolio Manager Jeffrey Schulze analyses this phenomenon and whether other developments have emerged.

Schulze says, “CPI inflation at 8.6% against the Federal Reserve’s 2% target is akin to doing 73 miles per hour in a 25 zone: it’s a big problem. Since last Fall, the Fed has been pushing progressively harder on the brakes, hoping to slow down the economy before an accident occurs. Yesterday, it slammed on the brakes with a 75-basis point (bps) interest rate hike.”

By slamming on the brakes this hard, there is the chance that the Fed can inadvertently create a second problem by slowing the economy so much that a recession occurs. “Sticking with the speeding car analogy, the economy is now at risk of a spinout from the Fed’s abrupt manoeuvres,” says Schulze.

Following the release of the May Consumer Price Index (CPI) and the University of Michigan Index of Consumer Sentiment preliminary June number, markets are pricing-in a more aggressive 75bps rate hike as the Fed’s next move. They are also projecting 3.25 additional percentage points in rate hikes this year. Schulze says, “If these additional hikes come to fruition in the second half of the year, they would represent the second-largest cumulative rate increase in the 12 months following liftoff since the mid-1950s. This rapid and substantial tightening will eventually cool the economy, which was already slowing given post-pandemic and reopening normalization as well as higher energy prices.”

In the end, Schulze says monetary policy “simply doesn’t work against supply shocks” such as higher energy prices resulting from geopolitical conflict. Energy prices could remain high despite the Fed’s hiking; which means that inflation won’t budge and more substantial tightening is yet to come, increasing the risk of recession. “While the cake is not yet fully baked, we believe the economy is now headed down a path where a recession is becoming modestly more likely than a softish landing,” says Schulze.

Looking at the ClearBridge Recession Risk Dashboard, economic conditions are currently strong and there are no signs of a broader slowdown. Credit Spreads has worsened from yellow to red with markets starting to pick up on these dynamics. Schulze expects further deterioration in the dashboard from indicators such as Housing Permits, Jobs Sentiment, Jobless claims, Retail sales, ISM New Orders and the Yield Curve.