Moreover, apart from this potential legislation, the U.S. economy should be experiencing significant fiscal drag in 2022. The Congressional Budget Office latest estimates still show the federal budget deficit falling from 12.4% of GDP last fiscal year (which ended on September 30, 2021) to 4.7% of GDP this fiscal year and 3.7% next fiscal year. Of course, this reduction in the deficit assumes no further stimulus legislation. However, apart from anything passed in the next few months, this may, in fact, be a quite realistic assumption, as Republicans are likely to take control of at least one house of Congress this fall and probably could not be induced to support further stimulus legislation unless the economy was demonstrably already in recession.
There is a strong argument that the fiscal policy has been too easy during both the Trump Administration and the Biden Administration so far, notwithstanding the obvious emergency caused by the pandemic. However, it would be a classic fiscal mistake to lurch from too much stimulus to too little.
The Federal Reserve could make a similar policy error. For almost 14 years, with the exception of a very brief period in late 2018 and early 2019, the Fed has maintained a negative real federal funds rate. This super-easy monetary policy has elevated asset prices and fostered financial speculation while doing little to actually stimulate economic growth. For this reason, the Fed should have begun to normalize monetary policy once it was clear that the economy was recovering strongly and adapting to the pandemic over a year ago.
By waiting, the Fed has left itself open to the charge that it has fueled inflation, which manifested itself, last week, in a 7% year-over-year increase in headline CPI. To some extent, this particular criticism is misdirected. The Fed’s easy money policies have contributed to fast-rising prices of homes and financial assets. However, soaring prices of consumer goods and services have much more to do with supply chain disruptions and earlier fiscal stimulus.
That being said, the Fed has now clearly pivoted to a much less dovish position. Their bond purchase program is on track to end in two months and multiple Fed speakers have now argued for a first increase in the federal funds rate in March. In addition, the minutes of the last FOMC meeting show that they are now actively looking to reduce their mammoth $8.8 trillion balance sheet with an eye to maintaining an upward slope on the yield curve as short-term rates rise.
If they carry through with this policy shift they may well succeed in boosting the 10-year Treasury bond yield to between 2.5% and 3.0% from its current 1.8% by the end of this year. This would likely entail a parallel upward shift in mortgage rates, slowing the housing market. Finally, this tightening could lead to a significant correction in financial markets, negating some of the huge gains seen in household net worth in recent years.
As with fiscal policy, if the economy were actually to fall into recession, this tighter monetary policy would surely be reversed. But by then, the damage would have been done.
If a recession were to occur, it would likely be shallow and short-lived. The recession, particularly if mirrored by a global slowdown, would likely mop up excess demand in the economy, returning the economy to a somewhat lower inflation environment. However, divided government would likely preclude significant fiscal stimulus while the Federal Reserve, chastened by the current inflation experience, might be less aggressive in deploying monetary easing to stimulate the economy than in the last two recessions.
For investors, a year of rising interest rates followed by a recession would represent a double challenge to more speculative investments. Higher rates would obviously be a problem for long-duration bonds and high-P/E stocks as well as more esoteric investments such as cryptocurrencies and NFTs. A more traditional recession, without the stay-at-home characteristics of the last one, would be much less profitable for goods retailers and technology companies. And a U.S. recession that put an end to Fed tightening could be dollar negative, enhancing the relative returns on overseas assets.
As I said at the outset, we don’t expect a near-term U.S. recession. It isn’t our baseline scenario. However, investors should diversify not because of what they expect but because of what they never expect that ends up biting them. It is also worth emphasizing that the pandemic recession and recovery have led to a very wide dispersion of valuations across capital markets. Any new scenario, which starts with increasing interest rates, has the potential to narrow that dispersion suggesting that, whether investors expect a recession or not, they should take steps today to ensure that they are not overweight in those assets that are obviously overpriced.
David Kelly is chief global strategist at JPMorgan Funds.