Odds of Fed achieving a soft landing don’t look good

AT THE end of trading on Tuesday (Nov 1), the federal funds futures market was pricing in an 83.5 per cent chance that the Federal Reserve would raise rates by 75 basis points to a target range of 3.75-4 per cent at its Wednesday (Nov 2) meeting.

What wasn’t – and still isn’t – known is what impact higher rates this year will have on the US economy and the rest of the world. As far as markets are concerned, the key questions are: when will the Fed taper the pace of its rate rises, and will there be a soft landing for the US economy?

So far, no one knows when tapering might commence and it’s unlikely that the Fed itself has any firm idea, since much would depend on incoming economic data. As far as the futures market is concerned, it expects rates to peak at around 5 per cent early next year and hopes that the Fed will start lowering rates by the end of the first quarter of 2023. Observers, however, have pointed out that with inflation running at a 40-year high of around 8 per cent, it may be necessary for rates to rise to at least that level, and that 5 per cent would be ineffective.

As far as achieving a soft landing goes, the odds do not appear encouraging. Economist Myron Scholes, who won the 1997 Nobel Prize in Economics for developing the Black-Scholes option pricing model, last month became the latest in a long line of experts who are forecasting a hard landing, mainly because the real rate of interest is too low – which means the Fed will have to increase “until such time as the real rate becomes positive, creating an opportunity for (the US) to grow again”.

But that will take “quite a long time”, Scholes said, referencing the experience of Paul Volcker’s Fed in 1980, when the central bank lowered the Fed funds rate to 8.5 per cent in June only to have inflation return, forcing Volcker to raise the Fed funds rate to 20 per cent in December. “I hope it’s a soft landing, but I fear that there are much greater odds that we’re going to have a harder landing or deeper recession, because of the need for the Fed to keep going,” Scholes said.

The International Monetary Fund (IMF) also recently warned that colliding pressures from inflation, war-driven energy and food price rises and sharply higher interest rates were pushing the world to the brink of recession and threatening financial market stability. In its World Economic Outlook, it said the global deceleration will be “broadbased”, and noted that the projection of 2.7 per cent 2023 growth is less than half of 2021’s 6 per cent expansion.The three largest economies – the United States, China, and the euro area – will continue to stall’’. The outlook is fraught with uncertainty, the IMF said, citing a 25 per cent probability that global growth will fall below 2 per cent next year and a 10 – 15 per cent chance that it will drop below 1 per cent.

So far, Wall Street stocks have enjoyed the occasional strong rally on hopes that the Fed will sooner rather than later taper its rate hikes, and ultimately achieve a soft landing. It would be prudent to bear in mind the rising chance that those hopes may not come to pass anytime soon.