Will the Federal Reserve Board be able to control inflation through aggressive interest rate hikes without creating a full-blown recession?

Schwab Chief Investment Strategist Liz Ann Sonders has doubts.

“There are more instances in the past of tightening cycles ending up in inflation versus a soft landing. That doesn’t automatically mean you establish as your base case a recession each time,” but with at least a portion of the yield curve inverting, indicators are pointing to “elevated recession risk,” Sonders said during a Schwab Market Talk webcast yesterday.

Even in a normal market cycle it’s hard for the Fed to engineer a soft landing, the veteran analyst noted.

“Now whether the unique circumstances connected to this cycle make it easier to land the plane softly, I’m skeptical about that given what they’re trying to do in combatting inflation and knowing that they can’t directly target supply chain disruptions. They can’t cause a ceasefire between Russia and Ukraine to bring energy and food prices down. Really what that leaves them with is trying to rein in aggregate demand and slow economic growth,” Sonders said.

Slowing economic growth in addition to fighting inflation is a tall task, she said.

“Even if a recession isn’t a lock, I think engineering a soft landing is arguably a little trickier this time than it has been in the past,” Sonders said.

Fed Takes Aggressive Stance
Kathy Jones, Schwab’s chief fixed-income strategist, said during the webcast that Fed officials have made no secret about their plan to move aggressively to raise rates. “We heard very clearly from various Fed officials ... that they plan to move fast and raise rates perhaps in 50 basis point increments instead of 25 basis points and get that short-term rate up to neutral—which in the Fed’s book is roughly around 2.5%.”

Federal Reserve Governor Lael Brainard said yesterday that “the committee will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting."

Inflation is currently at 7.9%. The Federal Open Market Committee (FOMC) will release minutes from its March meeting today which could provide further details of the central bank’s plan to reduce its $9 trillion balance sheet of Treasury securities and mortgage bonds.

Jones said it remains to be seen if the Fed will let up on the gas to tamp inflation in time. “If we’re right and things slow down later in the year and the Fed doesn’t have to be as aggressive as they’re talking about ... I’d say the positive risk reward is probably in that more intermediate to long-term part of the curve than in short-term where it’s already priced in.”

Sonders said Fed indicators such as the ever-decreasing spread between consumer’s assessment of their present situation and their expectations for the future present “a dour outlook.”

“The spread between these two indicators has never been as low as it is right now other than when we were already in recession or the lead-in to recession,” Sonders said. While GDP and the labor market have been strong and wage growth is up, “the weight of inflation” is weakening consumers’ expectations for the future,” she said.

Consumers believe that, “‘Yeah, things are OK right now, [but] I don’t anticipate them to stay well. I am looking at a pretty significant deterioration in my own situation six months down the road,’” she said.

“We’re also seeing a weakening in capital goods spending and in household durables so I think a lot of the consumer side of the economy metrics—and it really surged coming out of the lockdown phase—have at least started to roll over if not started to display inflation-type weakness,” Sonders said.

She said “the dynamics of the housing market are concerning right now. When I talked about some of the more cyclical areas of the stock market underperforming significantly this latest rally, that would be inclusive of household durables and homebuilders.”

With mortgage rates up, “you’re seeing mortgage finance companies recently underperform even in this rally. So, the messages are pretty strong that we may have started to roll over in terms of housing," she said. "But I think it’s a more benign move on the downside certainly than what happened back in ’08."