General

The U.S. Federal Reserve announced on July 27 that it would raise interest rates by 75 basis points, raising the target range for the federal funds rate to between 2.25% and 2.5%. This is the fourth time the Fed has raised interest rates this year and the second in a row by 75 basis points. Analysts believe that although the Fed continues to increase interest rate hikes, the inflation rate remains high, and the U.S. economy may enter a "stagflation-type" recession. At the same time, the spillover effect of the Fed's continued interest rate hikes should be vigilant.

Rate hikes may continue in September

Federal Reserve Chairman Jerome Powell said on the 27th that U.S. inflation is still well above the long-term target set by the Fed, and it would be appropriate to raise interest rates again sharply at the September monetary policy meeting.

In a statement released after the meeting, the Fed said inflation remained high, reflecting supply and demand imbalances related to the coronavirus, higher energy prices and broader price pressures. Meanwhile, the Ukraine crisis and related events are putting additional pressure on inflation and dragging on global economic activity.

According to the monetary policy implementation decision announced on the same day, the Federal Reserve will accelerate the "shrinking of the balance sheet" as planned from September, that is, increase the monthly shrinkage limit of US Treasuries to $60 billion, and increase agency bonds and agency mortgage-backed securities (MBS) 's monthly shrinking cap to $35 billion.

Reuters reported that the Fed has raised interest rates by 225 basis points so far this year, with policy rates now at what most Fed policymakers see as neutral and matching the highs of the Fed's last tightening cycle from late 2015 to late 2018.

The analysis pointed out that the latest policy statement did not give clear guidance on the Fed's next possible actions, and future decisions will largely depend on whether economic data shows that inflation is starting to slow. With recent data showing U.S. consumer prices rising more than 9% from a year earlier, investors expect the Fed to raise rates by at least 50 basis points at its September meeting.

The Chicago Mercantile Exchange Fed Watch Tool showed on the 27th that traders expected the Fed to raise interest rates by 50 basis points in September. The probability is 65%.

Mislav Matejka, head of global equity strategy at JPMorgan, believes that challenges in the momentum of U.S. economic activity and a weakening labor market could open the door for a more balanced Fed policy, leading to a peak in the dollar and inflation. UBS's base case remains that the Fed will re-raise rates by 50 basis points at its September meeting. Looking further, core inflation is expected to fall significantly, compounded by heightened concerns about economic growth, forcing the Fed to pause rate hikes after its December meeting and possibly even turn to rate cuts in 2023.

The bond market is showing signs of recession

A widely watched measure of the yield curve in the U.S. Treasury market extended its inversion after the Federal Reserve announced a 75 basis point rate hike. The 2-year Treasury yield was at one point 32 basis points higher than the 10-year yield, a multi-decade high. The 10-year treasury bond yield fell 6 basis points to 2.74% at one point, while the 2-year yield edged up to around 3.06%.

In March of this year, the 2-year and 10-year U.S. Treasury yields inverted for the first time since 2019, and as the Federal Reserve raised interest rates more aggressively, the inversion gradually widened. Short-term yields reflect investors' expectations for recent changes in central bank policy, while longer-term bond yields represent investors' expectations for medium- and long-term inflation, economic growth and interest rates.

When the economy slows and inflation expectations fall, long-term bond yields such as 10-year and 30-year typically fall, moving toward shorter-term bond yields such as 3-month and 2-year bonds, resulting in a flattening of yields; when When long-term yields are lower than short-term yields, the curve inverts, especially the 2-year and 10-year U.S. Treasury yield curve inversions are seen as a strong recession signal.

Desmond Rahman, an economist at the American Enterprise Institute, said that so far, the Fed's tightening of monetary policy has had a significant impact on financial markets. The stock and bond markets suffered sharp declines in the first half of the year, and growth in some economic areas began to slow. slow. At the same time, housing demand has cooled sharply due to rising interest rates and declining consumer confidence.

Goldman analysts said in a note to clients that the price of controlling inflation is an increased likelihood of recession. If the Fed continues to raise interest rates sharply, the economic growth rate will slow down sharply or even enter a recession. If the Federal Reserve's monetary policy becomes more aggressive than necessary, the possibility of a U.S. recession in 2023 will double from previously expected.

Increased risk of spillover effects

At present, the spillover effect of tightening monetary policy by the world's major central banks such as the Federal Reserve on emerging markets and developing economies is a major concern for the outside world. The US "Wall Street Journal" said that in the context of high energy prices, the ongoing crisis in Ukraine, and the global economy facing multiple downside risks, the Fed's accelerated shift to tighter monetary policy has put pressure on the world economy, not only making some developing countries in trouble, but also some developed countries. The economy has also been hit.

Japanese media and experts believe that due to the accelerated tightening by the Federal Reserve, the yen has depreciated by about 20% this year, and the impact of rising energy prices on the Japanese economy has been further amplified. Domestic prices in Japan rose rapidly, and the core inflation index rose year-on-year for 10 consecutive months; personal consumption was suppressed, and household consumption expenditure declined year-on-year for three consecutive months; trade deficit continued to expand. As of June, Japan had trade deficit for 11 consecutive months. The trade deficit in the first half of the year hit a new high since comparable statistics were available.

Rahman also pointed out that U.S. interest rate hikes have led to massive capital outflows from emerging markets, sharp currency depreciation, and raised the possibility of a wave of large-scale debt defaults in highly indebted emerging economies. Agence France-Presse also pointed out that the Fed's aggressive interest rate hikes again may further exacerbate the risk of capital outflows and currency depreciation in these regions.

James Morrison, an associate professor of international political economy at the London School of Economics and Political Science, said a rising dollar would make it difficult or even impossible for developing countries to pay interest on dollar-denominated debt. Some countries that rely on cheap imported goods may also experience difficulties. It's entirely possible that the U.S. response to high inflation could trigger a global recession, depending on how aggressively the Fed raises interest rates. Once the U.S. economy slows, its consumption of global goods and services will also be lower.