Macro Insights Weekly: The year of rising (real) rates
- We forecast US short-term real interest rates to go from -0.5% at end-2022 to +1.7% at end-2023
- Rising real rates will hurt home affordability and corporate profitability
- Some impact on labour markets and consumption is inevitable
- The balance of risk is not overwhelmingly one-sided
- Both inflation and growth could prove to be sticky, which would be major headwinds for markets
Commentary: The year of rising (real) rates
After a year of historic rate increases, 2023 will test the ability of US households and companies to absorb a prolonged period of high interest rates. We expect the Fed funds rate to reach 5% by the end of the first quarter, and then the policy rate to remain unchanged till end 2023. This is largely consistent with the median forecast of the members of the Federal Reserve’s Open Market Committee. It is widely expected that supply and demand conditions are aligned for inflation to decline next year, but not to the extent to make the monetary authorities comfortable enough to begin cutting rates. That would have to wait till the first quarter of 2024, in our view.
As we expect a gradual decline in price pressures through the course of the year, this would imply a substantial rise in real interest rates. As per our forecasts, short-term real interest rates, calculated as end-period Fed funds rate minus average core personal consumption expenditure inflation, will go from -0.5% at end-2022 to +1.7% at end-2023.
Will credit growth for personal and business spending and mortgage financing sustain under the envisaged 220bps of real interest rate increases within a year? We are doubtful. Such high rates are bound to erode home affordability, reduce corporate profitability, and impose pressure on firms to reduce employment. The labour market, still buoyant despite the outsized rate increases of this year, will eventually feel the pinch. We expect to see unemployment rise from 3.5% to 4.5% in 2023.
There is a good chance the recent trend softening seen in the cost of shipping, manufactured goods, energy, and food will persist, helping keep inflation on a downward trajectory, which is a major positive in the making for the global economy.
Global fixed income markets are pricing in that the monetary policy cycle is not only close to peak, but rates will be heading down in less than a year. These predictions are predicated on inflation and economic growth slowing substantially this year. We also expect both, but recognise that the balance of risk is not overwhelmingly one-sided. Inflation may well prove to be stickier, as could growth, as seen by US jobs and sales numbers in recent months.
Rising rates have already had a chilling impact on home prices; rents, and their contribution to inflation, are about follow. The job market ought to be the next shoe to drop, with the downsizing trend already seen in the tech sector spread to a wider set of sectors. That in turn should have a sobering impact on wages.
But it would be premature to ignore a scenario under which jobs, wages, and prices don’t weaken sufficiently and swiftly enough for the market’s expectation of a late 2023 rate cut cycle to materialise. Household and corporare debt ratios are low by historical standards, which could set the ground for surprising resiliency. That would put the Fed in quandary, as it faces weakening growth and yet to need to hold on to its policy leash. 2023 may well be the ultimate test of Fed credibility.
What does all this mean for Asia? With the exception of China, Asian economies were compelled to normalise monetary policy in 2022, pulled by the Fed’s actions. Inflation momentum has eased substantially in the region in recent months, but that doesn’t mean the room to ease policy is opening up. Even as growth slows, Asian policy makers would prefer to keep rates above the historically low rates seen during the pandemic. This would hold in particular if the year’s slowdown is driven by weak external demand, in our view.
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