As the Federal Reserve has slowed the pace of its interest rate increases recently, financial conditions in the American economy have eased as well.
The RSM US Financial Conditions Index has moved to only 0.4 standard deviations below normal as asset prices anticipate improved prospects for reduced inflation and a softer landing for the economy.
This presents a disconnect between the direction of monetary policy, which has become more restrictive as officials remain concerned about the impact of a still-tight labor market on inflation, and the financial markets through which monetary policy is transmitted to the real economy.
While the asset markets are seemingly ready to move beyond the impact of the Federal Reserve’s aggressive series of interest rate hikes, there is the lingering effect of those rate hikes on the real economy.
For instance, there is the glaring decline in corporate debt issuance that began in 2021 and continued through last year.
According to the most recent data from the Securities Industries and Financial Markets Association, the higher cost of capital and an increased recession risk have taken their toll.
The issuance of investment-grade high-yield debt, for example, plunged 77% last year from 2021.
We expect this decrease in issuance will have an adverse effect on business activity, risk taking and fixed investment as the year unfolds.
In the end, it could mean the difference between a recession later this year and a more muted slowdown.
The impact of rate hikes
.As higher rates of interest raise the cost of consumer credit and companies’ access to capital. consumer spending declines along with commercial profits.
The rate hikes created the conditions for the slowing of overall economic output last year, as pointed out by Federal Reserve Chairman Jerome Powell in remarks following the recent announcement of another 25 basis-point hike.
We expect further 25 basis-point hikes at the Federal Open Market Committee’s March and May meetings, which would push the policy rate up to a range between 5% and 5.25%.
The risk for the Fed is that its rate hikes will have more than a temporary impact on the ability of the economy to expand.
Investment in the housing sector—which declined by an annualized 26.7% in the final quarter of last year—has already taken a hit from the increase in mortgage rates. (Although the surplus of housing demand meeting a limited supply of housing suggests a limited setback.)
Nonresidential investment had a setback in the fourth quarter, marked by a 23.4% annualized quarterly drop in information processing equipment.
In addition, the issuance of corporate debt last year suggests the conditions for a slowdown in the business sector that could directly affect employment and therefore the wider economy.
For instance, we can see the pandemic’s impact on investment-grade issuance in the second half of 2020 and into 2021, and then the impact of inflation and the onset of the Fed’s yearlong program of rate hikes beginning in the second quarter of last year.
The rate hikes also had an impact on perceptions of growth and raised the cost of issuing less-than-investment-grade corporate debt. Not only has the cost of all debt shot up, but the risk of an economic slowdown and the potential of corporate default for more vulnerable businesses have increased as well.
The takeaway
Tighter financial conditions have laid the groundwork for reduced propensity to borrow and lend.
The result has been higher mortgage rates and a higher cost of commercial borrowing, which could have a lasting impact on the economy’s potential.
We anticipate the lagged impact of the Fed’s rate hikes to have an effect on commercial activity and the overall economy in the second half of this year.
