The Economy

GDP Contracts 0.9%, Fed Raises Rates 0.75% As Tightening Cycle Continues

"The Fed has a high pain threshold to get inflation back to target," warned analysts.

Less than one day after the Federal Reserve Open Market Committee (FOMC) raised the Federal funds rate by 75 basis points, the advance estimate for second-quarter GDP showed the U.S. economy contracted by 0.9%.

Although Fed Chair Jerome Powell insisted on Wednesday the U.S. economy was not in a recession, the FOMC statement did admit “recent indicators of spending and production have softened.”

With the GDP number confirming that statement, the road ahead for monetary policy gets rougher.

“The Fed has only raised interest rates back into line with its own estimates of the long-run neutral rate,” pointed out Fitch Ratings chief economist Brian Coulton in an email Wednesday. “Given where core inflation and the unemployment rate stand this underscores that monetary policy adjustment still has quite a long way to go.”

The FOMC is likely to move rates into restrictive territory, Powell noted, given unrelenting inflation and the tight labor market. 

“The Fed has a high pain threshold to get inflation back to target,” wrote Bank of America Securities’ analysts Mark Cabana and John Shin in a research note Wednesday. “This is consistent with [Powell’s] hesitance to say that the economy will not go into recession, and his statement that the risk of tightening too much in the short run is less than the risk of tightening too little.”

While financial markets’ immediate interpretation of the Fed’s message was dovish, Powell pushed back when asked about the possibility of interest rate cuts in 2023 should the economy take a recessionary path. The CME FedWatch tool showed markets were implying a 75% chance of 75 to 100 basis points of further rate increases in the last three FOMC meetings this year.

Still, Cabana and Shin said the “path to a soft landing has narrowed and will narrow further.” They predicted a recession in the second half of 2022, with the Fed pausing as rates reach restrictive levels.

Thursday morning’s GDP number, while evidence of a slowdown in consumer demand, “does not signal the early arrival of the inflation and Fed-tightening induced recession,” said Fitch’s Coulton.

“The labor market – one of the best indicators of the current state of the economy – remains resilient, consumer spending on services is picking up, and the fall in GDP is more than accounted for by the short-term dynamics of the inventory cycle.” 

Healthy average credit statistics suggest corporate issuers are relatively well positioned for the rate-tightening cycle, said Lyuba Petrova, head of U.S. leveraged finance at Fitch, in an email.