‘Financial markets are throwing in the towel’: Recession fears escalate as Fed slams brakes on the economy

The likelihood of significantly higher interest rates has tipped the odds of another recession within a year, economists say. However, some still hope the US can pull through a period of slow growth rather than outright decline.

In a move widely anticipated by financial markets, the Federal Reserve orchestrated another huge hike in US interest rates last week. What was unexpected was the central bank’s aggressive forecast of even higher interest rates in the coming year.

The surprise forecast triggered a sharp decline in the DJIA stock market,

as the realization trickled in that the Fed was determined to quell the highest US inflation in 40 years, no matter what the cost.

And the cost seems increasingly likely a recession, analysts say.

The risk of a recession next year “has now risen to over 50%,” said BMO Capital Markets chief economist Douglas Porter. “This more aggressive series of rate hikes will weigh more heavily on the US economy.”

Business leaders are also concerned. A survey of chief investment officers shows that 72% believe higher interest rates will lead to a recession, financial research firm Grant Thornton found.

The Fed last week raised a key short-term interest rate by three-quarters of a percentage point to a peak range of 3.25% and forecast a further 1.25 point hike by the end of the year, taking the benchmark rate to 4.5%.

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That’s not all. The Fed forecast that its short-term interest rate would rise as high as 4.75% in 2023 — and maybe even higher — in a head-on attack on inflation. Inflation has risen to 9.1% from less than 2% two years ago.

“I wish there was a painless way to do this,” said Fed Chair Jerome Powell after announcing the latest rate hike on Sept. 21. “That does not exist.”

Higher interest rates usually slow an economy by making it more expensive for people and businesses to borrow money.

So far, most of the pain caused by higher interest rates has been experienced by new and potential home buyers. For example, the interest rate on a 30-year mortgage has shot up to 7% from less than 3% a year ago. Since then, home sales have slowed.

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Higher rates also mean it costs more to buy a car, replace an appliance, make home repairs, or hold unpaid balances on a credit card.

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If consumers cut back on spending, companies are likely to respond as usual by stopping hiring or even firing workers. They will also borrow less and defer new investments.

The result: economic “pain,” just as Powell predicted.

“The Fed will likely have to accept a sustained slowdown in the economy, if not a mild recession,” Mizuho Securities chief economist Steven Ricchiutto said in a note to clients.

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US stock markets fell last week – and stocks fell again on Monday – after this new reality took hold.

Before last week’s Fed action, many investors had hoped the central bank would remain dovish and even cut interest rates next year to support a slowing economy.

“Financial markets are throwing in the towel and are now adamant that the Fed will do whatever it takes to contain inflation, including a recession,” said senior economist Bob Schwartz of Oxford Economics.

Now some, including Schwartz, fear the Fed may be going too far.

“By looking at the past, the Fed risks raising rates more than is needed to complete the task,” he said.

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According to economists, high inflation is not as ingrained in the economy today as it was in the 1970s and 1980s, when the Fed fomented two recessions in its fight to contain price pressures.

Powell has often referred to the Paul Volcker-led Fed and its fight against inflation four decades ago in an approving manner. But times are different, emphasize others.

For one thing, a far less unionized workforce means workers can no longer demand and receive higher wages. And the supply shortages caused by the pandemic that originally fueled the inflation spurt are beginning to ease.

Because of this, a dwindling but still sizeable number of economists believe a recession could be avoided.

Michael Feroli, chief US economist at JPMorgan, is sticking to his forecast that the economy will emerge from a recession, albeit only just. The Fed could pause rate hikes, he argued, if inflation eased faster than expected.

“We’re sticking to a soft landing,” he wrote in a report, referring to the Goldilocks scenario in which the Fed is able to kill inflation without triggering a recession. However, it is a goal that the Fed has rarely achieved.