Will Rising Interest Rates Lead to Soft Landing or Recession?

White puzzle pieces are the backdrop for a red line and successively taller red columns indicating rising interest rates.

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Editor’s note: This is part one of a three-part series about what the economy and markets could look like this year. Part two is What the Markets’ New Tailwinds Could Look Like in 2023. Part three is Five Investment Strategies to Focus on in 2023.

The year 2022 will forever be remembered as the year when the Fed, to combat the highest inflation in four decades, unwound the easy monetary policy of the past 15 years. Between March and December, the Fed raised interest rates seven times for a grand total of 425 basis points — bringing the fed funds rate to its highest level since 2007.

When It Comes to Cash Yields, Cash Is No Longer Trash

As if that wasn’t enough, in June, the Fed began a new “quantitative tightening” exercise to shrink its balance sheet, a process that adds further upward pressure to interest rates.

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While the Fed’s rate hikes have thus far had little impact on inflation, they’ve undoubtedly had a major impact on global financial markets. Stock and bond markets across the globe finished 2022 in the red. Virtually every major asset class finished down for the year.

One thing seems certain: 2022 was the year sobriety and common sense returned to financial markets. The prices of everything from stocks and bonds to real estate and cryptocurrencies are again re-tethered to interest rates. Consequently, monetary policy — specifically where the Fed lands on interest rates — will ultimately determine the direction of the economy and markets in 2023.

Is the Fed Using a Hammer to Drive a Screw?

As long as the Fed performs modest hikes as expected, there shouldn’t be a major market upheaval. If the Fed enacts more aggressive hikes, it will be detrimental to the economy. Further, the U.S. economy probably doesn’t have the productive capacity to sustain interest rates at current levels, let alone higher interest rates. For a long time, there has been a disconnect between the Fed’s narrative and what the data tells us. The Fed has been responsible for the doubling of mortgage rates, yet there has been little movement on inflation to show for it.

In some ways, their approach seems to stem from a misguided orientation that today’s inflation is caused by demand-side forces. The evidence suggests that what’s been causing inflation has less to do with consumer spending and more to do with COVID-related supply constraints and tight labor markets.

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Part of the Fed’s motivation is political. Every Fed board member, at one time or another, has promised Congress they would not hesitate to hike rates to combat inflation. However, there’s nothing the Fed can do to influence supply. If indeed the issue was too much quantitative easing or too much fiscal stimulus, we would have likely seen inflation come down more by now.

Soft Landing or Sustained Recession?

The economy today is now threatened more by recession than inflation. A steeply inverted yield curve, a declining Purchasing Manufacturing Index, the highest mortgage interest rates in 15 years, a strong dollar and slumping overseas growth all suggest a recession. Economists surveyed by Bloomberg forecast a 70% chance of a recession in 2023. Economic forecasts are notoriously imprecise, but what they lack in precision they typically make up for in directional accuracy.

However, the window for the Fed to achieve a soft landing appears to be narrowing rapidly, given the Fed’s hawkish tone and baffling forecasts that ignore November’s decline in inflation. There is a very real possibility that the Fed overtightens and pushes the economy into an unnecessary recession. But we suspect that they’ll change course on rates before that happens. It’s quite possible the Fed’s overly tight monetary policy is inflicting damage somewhere in the financial system, but the nature of the damage won’t become readily apparent for some time.

A Silver Lining Playbook for a Sensible Market in 2023

One silver lining in 2022 is that it helped re-ground investors in the basics: fundamentals matter, predictions should be taken with a healthy dose of skepticism, and prudent planning prevails in the long run. More speculative asset classes, like cryptocurrencies and growth stocks, saw exceptionally steep losses. Relative outperformance, albeit still negative, was to be found in previously unloved asset classes like dividend-paying stocks, value stocks and low-beta stocks as well as short-duration bonds. Gone are the days of digital assets with no tangible value outperforming solid companies with reliable cash flows. The same could be said for any number of speculative asset classes — growth stocks, SPACs, NFTs, etc.

The Markets Were Miserable Last Year, But That’s Great News

It’s important to keep in mind that the economy isn’t the market. Likewise, the market isn’t the economy. Predicting the future is both an art and a science. The past 12 months have sadly reminded us that we live in a world of harrowing risks that could derail even the most elegant economic forecasts. The war in Ukraine, mounting tensions across the Taiwan Strait, the rise of a new COVID-variant or even public unrest in Iran could derail the global economy in the year ahead.

Certified Financial Planner Board of Standards Inc. (CFP Board) owns the CFP® certification mark, the CERTIFIED FINANCIAL PLANNER™ certification mark and the CFP® certification mark (with plaque design) logo in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors is registered as an investment adviser with the SEC. Content is for educational and illustrative purposes only and does not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Some of the research and ratings shown in this presentation come from third parties that are not affiliated with Mercer Advisors. The information is believed to be accurate, but is not guaranteed or warranted by Mercer Advisors. Past performance may not be indicative of future results. This document may contain forward-looking statements including statements regarding our intent, belief or current expectations with respect to market conditions. Readers are cautioned not to place undue reliance on these forward-looking statements. While due care has been used in the preparation of forecast information, actual results may vary in a materially positive or negative manner.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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As Chief Investment Officer at Mercer Advisors, Don is responsible for setting the strategic direction of the firm's investment platform, chairing the firm's investment committee, overseeing all investment-related communications, and the prudent stewardship of the firm's assets under management. His expertise is in the areas of fiduciary oversight, economics, financial mathematics, portfolio management, corporate finance, and taxation.