The US economy faces its toughest hurdle since the COVID-19 pandemic hit: red-hot inflation. To bring inflation back to its 2% target, the US Federal Reserve has raised interest rates significantly. It is expected to continue pushing it further to cool demand.

In August, the Federal Reserve reaffirmed its intention to stamp out inflation, so policy will likely remain restricted for a long time. With the Fed less inclined to rescue at the first sign of market turmoil, investors are grappling to see if the economy can weather this storm.

Higher ratesโ€”and the often lower prices of financial assetsโ€”can lead to a tightening of financial conditions, which is the transmission mechanism of monetary policy to affect the economy. In the first half of this year, the Fed engineered the second strongest tightening of financial conditions in history outside of a recession. A third of the move had been phased out by mid-August.

With financial conditions advancing in the opposite direction of the Fed’s plan, no consistent loud drumming from Fed officials has left any ambiguity that the central bank is committed to taming inflation and will keep interest rates higher for longer, if necessary.

That tough talk, culminating with Fed Chairman Jay Powell’s Jackson Hole speech, helped trigger a reversal: Financial conditions are back near their mid-June peak.

Wary of the mistakes of the 1970s, when Fed monetary policy did not remain constrained long enough to fully tame inflation, the Fed now appears prepared to tolerate emerging fissures or even shallow recessions to avoid a repeat of the 1970s.

This is in stark contrast to the post-global financial crisis era, when the central bank rushed to ease conditions amid weak growth and low inflation to avoid a recession.

In the recent past, โ€œFed Askingโ€ has been replaced by โ€œFed Asking,โ€ a fact that investors are still adjusting to.

Heading into 2022, the Fed was expected to raise interest rates by only about 75 basis points. Instead, it has already tripled that (225 basis points), with more than 200 basis points priced in Fed fund futures. The overall tightening could exceed 5.5 times the size of the initial forecast.

Besides raising interest rates, the Fed has implemented a quantitative tightening program to remove excess liquidity, which has now reached its stable state of $95 billion per month. As economic indicators of money supply deteriorate, there has also been a deterioration under the surface in housing permits, job sentiment, profit margins, credit spread and the yield curve.

This is in line with the rising odds of a recession next year, but a recession is still not unavoidable. While Fed officials have been stubborn in their comments, they have stressed their intention to remain dependent on the data. The new information could lead to a shift in the Fed's direction, dramatically reducing the odds of a policy-driven recession.

A widespread and sustained reduction in inflation must occur in order for the Federal Reserve to stop raising interest rates.

Recession can be avoided without the Fed pivot - the US economy is back to normal after a period of post-COVID pandemic strength. This recovery started and stopped, however, which makes separating the signal from the noise even more difficult.

Credit margins are an example. Motivated by fiscal and monetary stimulus designed to create excess liquidity, it has largely tightened from pandemic lows, a potential signal of a recession. But at the absolute level, credit spreads remain consistent with economic expansion. Our model can be confused by normalization after a period of very strong growth, but we should respect this signal rather than assuming it is a red herring.

Ultimately, the future trajectories of the economy and financial markets cannot be known.

A series of violent sell-offs has followed the V-shaped recovery of the past 15 years with the start of the Fed, but this system could evoke an entirely different environment. Both bulls and bears can get frustrated if markets remain range bound and choppy before clarity leads to a breakout in either direction.

Previous similar environments have proven favorable for active stock collectors. With a balance of risks indicating elevated chances of a recession, we prefer leaning towards higher quality defensive stocks.

Jeffrey Schulz, CFA

CFA
, director and investment strategist at ClearBridge Investments, a Franklin Templeton company. His forecasts are not intended to be relied upon as a prediction of actual future events, performance or investment advice. Past performance is not a guarantee of future returns. Performance source: internal. Standard source: Standard & Poor's.