The Fed’s Dilemma

  On June 16, Beijing time, the Federal Reserve concluded its two-day June interest rate meeting, announcing a 75 basis point interest rate hike, raising the benchmark interest rate to 1.5%-1.75%. It was the largest single rate hike by the Fed since 1994. Since 2022, the Fed has raised interest rates by a cumulative 150 basis points.
  The Fed’s aggressive rate hikes may only be halfway there. According to the benchmark interest rate dot plot given by Fed officials, it is expected that by the end of 2022, the federal funds rate will be raised to 3.25%-3.5%. This means that in the four meetings in the second half of the year, the Fed needs to raise interest rates by 175 basis points.
  In May, the US CPI rose by 8.6% year-on-year, up 0.3 percentage points from the previous month, and continued to hit a new high for inflation in 40 years. In the face of rising inflation, the “temporary theory” and “peaking theory” of inflation have been falsified one after another, and consumers’ inflation expectations have risen rapidly. Runaway inflation has forced the Fed to take a more aggressive approach to rebuilding its credibility.
  Of course, aggressive interest rate hikes may also cost the U.S. economy a huge price, which will slow down in the future, and even the possibility of a recession is rising. If the U.S. economy really falls into recession around 2024, it will also become a stumbling block for U.S. President Biden to win re-election.
  Global capital markets appear turbulent and have revealed deep “concerns” about a U.S. recession. As of June 16, the S&P 50 index has fallen by 23% in 2022, the Nasdaq index has fallen by 32%, and US stocks have entered a bear market channel; the German DAX index and the French CAC index will also fall by nearly 17% in 2022. In the foreign exchange market, the U.S. dollar index exceeded 105, the highest in 20 years, and major non-U.S. currencies depreciated sharply.
  Economist Lawrence H. Summers has long been skeptical that the Fed can keep inflation in check without causing a recession. “Historically, when we have severe inflation, we’ve never actually avoided a severe recession in the economy.” Summers was Treasury secretary under Clinton and director of the National Economic Council under Obama. In the first half of last year, the Federal Reserve’s “inflation tentative theory” was severely criticized.
  The White House may not sit still with high inflation either, as the White House and Democrats are reported to be negotiating a new economic plan aimed at cutting deficits and fighting inflation that could make the U.S. economy slide even faster. Biden is also likely to ease tariffs on China, a way to moderate U.S. inflation.
  The Fed’s aggressive interest rate hikes will affect the global economy and capital markets in several ways: one way is that market uncertainty increases, global risk appetite declines, and capital tends to withdraw from high-risk emerging markets; another way is , the US dollar appreciates sharply, and those economies with more US dollar foreign debt will face higher debt burdens, which may lead to debt crises; the third way is that if the Fed’s aggressive interest rate hikes trigger an economic downturn or recession, global trade activities will decline . For China, it has mainly indirectly affected China’s capital market by changing risk appetite. The possible future recession in the United States will lead to a decline in China’s exports and directly affect the Chinese economy.
Largest single rate hike since 1994

  At the Fed’s interest rate meeting in June, the Fed decided to raise interest rates by 75 basis points, and the benchmark interest rate was raised to 1.5%-1.75%, which was the largest single rate hike by the Fed since 1994.
  The 75 basis point rate hike this time gave the market insufficient time to prepare. Because in the week before the meeting, the market generally expected only 50 basis points of interest rate hike this time. But the U.S. May inflation data released on June 10 continued to hit a new high, completely disrupting the Fed’s rhythm.
  CITIC Securities believes that after the “inflation temporary theory” and “inflation peak theory” were falsified, the Fed’s misjudgment of the inflation situation led to its previous forward guidance for raising interest rates by 50 basis points in June and July invalid. Its credibility is slipping away.
  In the recent turmoil of interest rate hikes, the “forward guidance” the Fed has been proud of has been criticized. Because just 3 months ago, the “forward guidance” given by the Federal Reserve was to raise interest rates to 1.75%-2% in 2022; and now the benchmark interest rate dot plot of Fed officials believes that interest rates need to be raised to 3.25%-3.5% this year. %. Such a rapid and dramatic correction leaves the market at a loss.
  Summers criticized that the Fed should resist the broad concept of “forward guidance,” which is just one of those seemingly “elegant” academic views that are hard to work out in practice because the central bank doesn’t know and can’t know itself What will be done in the future. Most of the time, “forward guidance” is stupid and the market doesn’t really believe it. Now that “forward guidance” has been given, you feel compelled to follow through, so it steers policy away from what should have been the best path.
  In a subsequent press conference, Fed Chairman Powell said, “We expect continued rate hikes to be appropriate. At the next meeting, a 50 basis point hike or a further 75 basis point rate hike is possible.” However, Powell Acknowledging that this 75 basis point hike was an unusually large move, and expecting “this magnitude will not become the norm” going forward.
America may pay the price of recession

  After the Fed aggressively raised interest rates by 75 basis points, U.S. stocks plummeted, U.S. bond interest rates also fell by nearly 20BP, and gold rose. CICC believes that the market’s trading logic has turned to fears that the Fed may raise interest rates too quickly and may trigger faster recession fears.
  At the press conference, Powell said the Fed will not try to induce a recession in the U.S. economy, and there are no signs of a broader slowdown in the U.S. economy, nor a significant slowdown in consumer spending.
  Even if a recession is not induced, a future U.S. economic downturn is inevitable. Federal Reserve officials also gave their latest growth forecasts, with a median forecast for GDP growth in the fourth quarter of 2022 of 1.7%, a sharp cut of 1.1 percentage points from March.
  Huachuang Securities believes that the sharp and rapid tightening of monetary policy by the Federal Reserve has brought about a “mistaken killing” of demand. Rising interest rates combined with high inflation, and the switching of consumption patterns after the epidemic subsides in 2022 will jointly reduce the demand for commodities. A leading indicator of U.S. demand for physical goods, movements in freight activity suggest that underlying demand for goods from U.S. consumers is slowing. The rise in long-term interest rates has driven the 30-year mortgage interest rate to rise from 3.1% at the end of last year to more than 5.1%, superimposed on high housing prices, US real estate sales have fallen sharply since 2022, and new housing starts have also slowed down significantly.
  It is a cost-effective “sale” to control high inflation at the cost of some economic downturn. However, the Fed’s expectations may only be the desired outcome.
  CICC believes that according to the current pace of interest rate hikes, the spread between the March maturity and the 10-year US Treasury bond may invert after the third quarter. According to historical experience, this inversion of interest rate spread may correspond to the coming of a subsequent recession; in addition, after the actual financing cost of enterprises generally exceeds the return on investment by 250BP, the pressure of economic recession will increase.
  Summers believes that the latest CPI report shows that inflation will not fall due to subjective will. The “temporary” theory is wrong, the Fed needs a deep recession to bring inflation, which is above 8% and accelerating, to an acceptable level.
  There is also a worse possibility, that is, the US economy will fall into stagflation. In other words, the Fed’s aggressive rate hikes have pushed the U.S. economy into recession, but inflation remains high.
  Powell also emphasized that the mechanism by which the Fed’s tightening affects inflation is to raise interest rates and shrink the balance sheet to tighten financial conditions and transmit them to the demand side. By curbing demand to match the current tighter supply, the goal of curbing inflation is achieved. As for energy and food prices, geopolitical factors, supply chain factors, and fiscal and job market structural factors in aggregate inflation, the Fed is helpless.
  The high inflation in the United States this time is not only due to demand-side reasons such as the Federal Reserve’s large water release in the early stage, but also supply-side reasons such as the damage to the supply chain caused by the epidemic and the increase in energy prices due to the conflict between Russia and Ukraine. Even if the Federal Reserve significantly reduces demand, the contradictions on the supply side may still keep inflation high, just like in the 1970s, the continuous rise in crude oil prices caused Europe and the United States to fall into stagflation.
Impact on the global economy and markets

  The Fed’s aggressive rate hikes have an impact on the global economy and markets in several ways.
  First of all, the Fed’s unexpected rate hike has added huge uncertainty to the global market. The volatility of the capital market has intensified, the global risk appetite has dropped significantly, and funds will flow out of emerging markets. In the first quarter, the Fed’s interest rate hike expectations continued to heat up, and the volatility of A-shares also increased, and there was a certain degree of outflow of foreign capital.
  Second, the Fed’s interest rate hike will push up the US dollar and US bond interest rates, and the debt burden of companies and countries with a large amount of US dollar debt will increase significantly, which will easily lead to a US dollar debt crisis.
  Finally, the U.S. economy could slip into recession and the global economy would slow sharply, which would lead to a contraction in global trade activity. This situation has the greatest direct impact on China’s economy, and China’s exports may decline.
  Major international institutions have recently lowered global GDP growth rates. The World Bank’s latest “Global Economic Outlook” report significantly lowered the global GDP growth rate in 2022 to 2.9% from the 4.1% forecast at the beginning of the year. The OECD also slashed its forecast for global economic growth in 2022 to 3% from 4.5% previously, and expects global growth to decline further to 2.8% in 2023.
  For a long time after the epidemic, China’s exports have maintained a better export growth than before the epidemic by taking advantage of the advantages of the global industrial chain and the recovery of the global economy, which has played an important supporting role in China’s economic recovery after the epidemic. If the global economy slows down sharply in the future, China’s export growth rate will inevitably decline.

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