BLACKROCK INVESTMENT INSTITUTE

Brace for impact: damage from rate hikes is growing

Dec 22, 2022

By Alex Brazier and Filip Nikolic | Central banks across major economies have embarked on one of the fastest rate-hiking campaigns we’ve seen since the 1980s. We knew the economic impact of that would take some time to come through – but now it’s starting. Here we look at the U.S.

Damage has started

More and more indicators of economic activity are starting to flash red. Take a look at the heatmap below. It shows the state of various economic indicators in the U.S. An increasing number are indicating significant stress and reaching levels not seen since the global financial crisis. That’s particularly the case for the most interest-rate-sensitive parts of the economy – like housing, where the impact of higher rates is typically seen first. Mortgage costs have surged to nearly 7%, their highest level since before the financial crisis. That has led to a massive 25% drop in sales of new homes, according to U.S. Census Bureau data.

 

Fed Chair Powell has himself acknowledged that the Fed’s rate rises are starting to affect demand in interest-rate-sensitive sectors and that the full effects are still to come.[i] If the damage spreads as it has in previous rate-hiking cycles, we expect the red to move down the heatmap, seeing the effect next in lending conditions and in investment intention. Then comes the impact on consumers. CEO confidence has already deteriorated to the lowest level on record. And capital spending plans are being delayed: a Philadelphia Fed index of capital spending plans shows the biggest 12-month fall since the financial crisis. [ii]

 

As the impact of interest rate hikes comes with a time lag, further economic damage from the rate hikes that have already happened is still in the works for 2023.

This heatmap of economic damage shows a number of U.S. housing indicators flashing red, most industrial indicators flashing amber, the consumer savings rate flashing red and retail sales growth moving from green to amber.

Source: BlackRock Investment Institute, with data from Mortgage Bankers Association of America, U.S. National Association of Home Builders, U.S. Bureau of Economic Analysis, National Association of Realtors, The Conference Board, National Federation of Independent Business, U.S. Federal Reserve, Federal Reserve Bank of Philadelphia and U.S. Census Bureau, December 2022. Notes: The heatmap illustrates the level of economic damage by comparing each series to its own history over the period 2006-2022. We show the current period (2017-2022) and the global financial crisis (2006-2009). The heat map is colored to show red (most damage) to green (least). For mortgage rates higher values are red, lower values are green.

      

How much more damage is to come?

To assess this, we looked at 20 published models calibrated to match the way the U.S. economy typically works. We look at what these models say about the way economic activity reacts to changes in interest rates. We take the average of the modelled responses and assume the Fed will raise rates to 5% early next year – even though they could well go even further than that. Result? We’ve barely scratched the surface of the damage that the rate hiking cycle will create. Based on those models, we estimate that only a fifth of the ultimate effect has manifested so far. Peak pain won’t come until late 2023.

 

By then, we expect the damage to have spread more broadly and deeply through the economy: we estimate GDP will be nearly 2% lower in the second quarter of 2023 than would have been the case if the Fed had left rates unchanged since March 2022. See the Growth hit from Fed hikes chart below.

This chart shows that the Fed's existing rate hikes will increasingly detract from U.S. growth in coming quarters. If rates reach 5%, the chart shows that the hit to growth is likely to peak in the second half of 2023 at around 1.8% off GDP.

Source: BlackRock Investment Institute, Institute for Monetary and Financial Stability, Goethe University Frankfurt, December 2022. Notes: The orange bars show the estimated fall in growth due to hike rates already done by the Fed. The green shows the estimated impact of additional hikes up to 5%. The black line shows the total impact. We calculate this by taking the average impulse response of output to policy rate from 20 different US-calibrated structural models. To be on the conservative side, we select these 20 model impulse responses by trimming outliers in IFMs Macroeconomic Model Database (otherwise the estimated impact would be even higher).

  

Recession foretold

A 2% hit to growth is massive. But consumer spending is holding up well – it was one of the biggest contributors to growth this year – and the U.S. economy grew by 2.3% on average each year from 2010-2019 [iii], so there is a buffer before growth actually turns negative. Does that mean the U.S. can weather the hit without falling into recession?

 

We don’t think so. Rate hikes won’t be the only drag on U.S. growth in 2023. Fiscal policy – local, state and federal tax and spending plans – will add to that drag, according to the Brookings Institution. [iv] And we think consumer spending will weaken significantly next year as people’s pandemic savings run out.

 

Overall, we think that adds up to a mild recession. But that’s a big deal relative to what we’d normally expect in terms of U.S. growth. And with the U.S. economy having effectively stagnated through the first three quarters of 2022, the cumulative lost output over two years will add up.

 

Watch out for our next blog post where we’ll explain why we see consumer spending slowing down in coming months – and why, crucially, the Fed isn’t going to come to the economy’s rescue like it has done in past periods of weakness.

 

Bottom line: We don’t see those flashing red lights switching off any time soon.

 

[i] https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20221214.pdf

[ii] https://www.philadelphiafed.org/surveys-and-data/regional-economic-analysis/mbos-2022-12

[iii] According to data from the U.S. Bureau of Economic Analysis.

[iv] https://www.brookings.edu/interactives/hutchins-center-fiscal-impact-measure/

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