Morgan Stanley
  • Wealth Management
  • Mar 22, 2022

Can the Fed Engineer a Soft Landing?

As it begins raising interest rates, the Federal Reserve hopes to contain inflation without tipping the U.S. into recession. Will it succeed?

The Federal Reserve showed clear resolve last week in its commitment to fight inflation. Not only did the central bank raise interest rates, as expected, by 0.25 percentage points, it signaled six more hikes in 2022 and another four in 2023—a more hawkish direction than many predicted.

But whether the Fed will succeed in guiding the economy to a soft landing, by taming inflation without stunting economic growth, is less clear. 

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In the wake of the announcement, markets rallied, though the relief was short-lived, judging by subsequent bond-market action:

  • Inflation expectation measures recovered to their previous highs;
  • Treasury yields that had soared to cycle highs leading up to the Fed’s meeting wound up stalling; and
  • The yield curve flattened, suggesting increasing concern about economic growth and the potential for policy missteps.

The Morgan Stanley Global Investment Committee agrees that there are reasons to be cautious. While we are far from calling a U.S. recession, we do think there are two substantial risks investors should keep in mind as they weigh portfolio positioning for the months ahead.

Rate hikes alone may not be enough to tame inflation

Borrowing has not been a major driver of inflation during the current economic cycle, so hiking rates—and making it more expensive to borrow—may have limited effect. Over the past 12 years of near-zero rates, borrowing costs have stayed incredibly low, and inflation, until only recently, had been relatively muted.

However, ample cash balances among businesses and households appear to be what’s driving much of today’s inflation-fueling excess demand. What’s more, many of the recent supply-chain problems behind today’s inflation have nothing to do with the Fed’s baseline rates; they stem from effects of COVID, deglobalization, demographic change and geopolitical-related commodity price surges.

As such, we believe a mix of policy action is needed to combat inflation—not just rate hikes, but a reduction of the Fed’s nearly $9 trillion balance sheet as well. Morgan Stanley’s economics team expects the Fed to run off about $500 billion through year end. Despite this, there is still significant uncertainty about how much liquidity withdrawal the market and economy can tolerate before becoming destabilized.

The global consumer-spending outlook remains uncertain

Consumer spending is still heavily skewed toward goods. However, as demand normalizes back toward services, demand for goods could weaken just as supply-chain bottlenecks are clearing and inventories are rebuilt. This could threaten the profitability of goods-producing companies.

Trying to gauge how this shift might unfold is particularly challenging today, with consumers sending conflicting signals. On the one hand, sentiment continues to deteriorate (the University of Michigan Sentiment Index sits at an 11-year low). On the other hand, low sentiment has yet to dent spending: Retail sales in February were up slightly month-over-month and 15.9% higher year-over-year. Importantly, looking ahead, consumer attitudes toward income prospects are gloomy, suggesting future spending may not be as robust. Add to all this the likelihood of weakening international demand due to geopolitical instabilities, and we have a rather muddy outlook, with possibly greater risks to the Fed’s efforts.

As we’ve noted in recent weeks, this environment of stubborn inflation and lower growth, at a particularly fraught time for the global economy, will likely be more detrimental to stock indices than to the aggregate economy. Investors will need to adjust expectations and resist chasing reflexive bounces in stocks. The "buyable bottom" in equities is not yet here, in our view, and when it arrives, opportunities will be found in new market leadership.

As for fixed income, we believe Treasury rates are closing in on theoretical cycle peaks and that value is beginning to be restored. Investors could consider revisiting Treasuries and investment-grade bond positions as a potential hedge to ongoing stock volatility.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 21, 2022, “Mix Matters.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

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