Response to inflation is likely to dominate economic policies

While higher interest rates are the go-to move to temper inflation, the efforts to restrict money supply also introduce the risk of a recession.

This article is one in a series of midyear outlooks for 2022 by the InvestmentNews team.

Any kind of good news related to the economy or the financial markets in the second half of the year will most likely be paired with some bad news, because that’s where we are in the economic cycle.

The Federal Reserve was probably slow to react, but now that it is taking steps toward fighting the pace of inflation as it teeters at a 40-year high, financial advisers and market watchers are anticipating higher interest rates ahead.

The equity markets, slogging through a brutal start to the year, have absorbed the Fed’s most recent rate hike, a 75-basis point move that marked the biggest hike in nearly 30 years.

KEY RATE ALMOST DOUBLED

The ripple effect has been swift, as illustrated by the rate-sensitive mortgage market. According to Bankrate.com, the national average for a 30-year fixed-rate mortgage is at nearly 6%, up from 3.2% at the start of the year.

While higher interest rates are the go-to move to try and temper inflation, the efforts to restrict money supply are also introducing the risk of an economic recession.

“Unfortunately, the cure for higher prices is frequently higher prices,” said Jim McDonald, chief investment strategist at Northern Trust.

McDonald tends to generally find the silver lining in his outlooks, which helps explain why he thinks the consensus estimate from Wall Street economists for a 33% chance of a recession next year is too high.

He also has a “high-to-mid single-digit return for equities over the next 12 months.”

The consensus forecast has the Fed hiking by another 200 basis points over the next six months to push the overnight rate to around 3%, but McDonald believes that forecast is too high.

“We’ll be in an environment over the next six months where somewhat bad economic news is good news for the markets because that will indicate that the Fed’s actions are having some impact on demand and should abate inflation pressures,” he said.

“The fed won’t care about … economic growth if inflation isn’t slowing.”

Jim McDonald, chief investment strategist, Northern Trust

Relying on hindsight, McDonald said it appears the mountains of stimulus spending to help save the economy during the peak of the pandemic was a bit overdone, and the current state of economic malaise is the price of it all.

“We put too much money into the system,” he said. “Inflation is global right now, but if we had to simplify what is causing the inflation problems, the U.S. has been the most egregious in the amount of money that was printed.”

The bottom line, according to McDonald, is that the second half is Fed dependent, meaning it’s “inflation dependent.”

“The Fed won’t care about the stock market or economic growth if inflation isn’t slowing,” he added.

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