Rate hikes may slow growth this year, but the longer-term outlook could strengthen as monetary policy shifts to neutral and prices stabilize.

The war in Ukraine has driven up the price of oil, gas and other commodities—leading to weakened global growth. Add soaring inflation and tight monetary policies to the mix, and the economic outlook for the rest of the year is far from robust.

While these developments have tempered economic forecasts for 2022, they may promote a stronger outlook for the next several years. Keep an eye on these economic trends, which may define the remainder of the year.

Interest rates: Hikes are coming

The tight labor market and above-target inflation have set the stage for the Federal Reserve to fully remove its pandemic-era monetary support. Policymakers have signaled their willingness to continue hiking rates in half-point increments—at least at the upcoming summer policy meetings and then more gradually this fall. This would return the Fed’s interest rate to neutral territory by the end of the year.

  • A neutral level of policy rates would imply that monetary policy is neither accelerating nor restraining economic growth.
  • Economic expansion would be expected to slow to the economy’s underlying potential growth rate of 1¾ to 2 percent as monetary support is removed. But the economy is likely strong enough to continue growing under its own momentum.
  • Futures markets are pricing in a steep rise in interest rates. Eurodollar futures and Treasury yields have recovered their pre-pandemic highs.

It’s common to hear concerns that persistent inflation will force the Fed to continue hiking interest rates well past neutral territory. But fears that the Fed is headed toward a restrictive monetary policy are premature.

  • Inflation is being driven by restrictions in the supply of vital goods. Higher rates will do little to help increase the supply of goods, which should return to normal later this year.
  • Raising borrowing costs above the neutral range would likely lead consumers and businesses to pull back on purchases and capital expenditures.
  • This scenario would contain prices, but it might also tip the economy into recession and cause unemployment to spike.
  • If price pressures subside over the next year as expected, the Fed is likely to hold rates near their natural equilibrium of 2-3%. Policymakers’ forecasts do not call for rates to exceed 3% in the coming years.
  • Neutral interest rates could accompany a period of sustainable growth, stable prices and low unemployment.
  • Stable long-term inflation expectations held by bond investors and professional forecasters will be reassuring to the Fed once it removes its accommodative policies later this year.

Real estate: Housing could feel the pinch

The housing market is uniquely sensitive to rising interest rates, since most home purchases are financed with long-term mortgages. Higher borrowing costs could erase some of the pandemic-era runup in home prices, which was largely driven by historically low mortgage rates.

  • Mortgage rates have already climbed two percentage points from their pandemic low, reducing potential homeowners’ purchasing power by around 22%.
  • With homeownership growing more expensive, institutional investors could seize the opportunity to develop more rental housing.
  • A price slump may not slow down residential construction activity because there is still such a significant undersupply in the nation’s housing stock.

Trade: Supply chains may face cross-currents

Inflationary pressure is likely to ease in the second half of the year as supply chains return to normal, regardless of tightening from the Fed.

The supply chain bottlenecks that drove prices higher are finally starting to ease. Price pressures have been concentrated in durable goods, especially motor vehicles and electronics. However, geopolitical events overseas may complicate the flow of goods.

  • China’s recent COVID-19 shutdowns may cause new disruptions in global merchandise flows.
  • Commodities markets are also being roiled by the ongoing war in Ukraine. Energy markets are especially tumultuous as the war redirects global supplies.
  • These disruptions have caused growth forecasts to be downgraded for the Eurozone and China.

Currency: The dollar should stay strong

The Fed’s tightening is happening sooner than similar action by other countries’ central banks—sending the dollar higher.

  • The Bank of Japan is still aiming to hold 10-year JGB yields down to stimulate the domestic economy.
  • The European Central Bank has been reluctant to tighten in the face of economic dislocations caused by the war in Ukraine.
  • The Bank of China is maintaining an accommodative monetary posture as the nation faces a wave of COVID-19 lockdowns.

This disparity has sent the trade-weighted value of the dollar up 10% against foreign currencies. The dollar’s strength is pushing down the cost of imported merchandise, which could shave a full percentage point off inflation in the second half.

Markets: Rising rates and geopolitical risks

Stocks have fallen from record-high valuations as interest rates rise, but the market should stabilize as price pressures ease and the Fed approaches a more neutral posture. The market’s losses also likely reflect fears of further economic dislocation from the war in Ukraine.

  • Investors have always understood that interest rates would eventually rise. The market has now discounted the removal of monetary stimulus.
  • At the same time, profits remain at historically-high levels, thanks in part to actions taken during the pandemic that have boosted efficiencies.

What to watch

The evolution of price pressures will determine how the second half plays out. Watch for the inflation expectations implied in bond yields to settle toward the Fed’s 2% target.

The Fed will release a new interest rate forecast after its June 15 meeting, showing policymakers’ expectations for the trajectory of rate hikes.

Originally published by JIM GLASSMAN, HEAD ECONOMIST, COMMERCIAL BANKING, AND GINGER CHAMBLESS, HEAD OF RESEARCH, COMMERCIAL BANKING