Q&A: An Economist’s View on Recent Macroeconomic Impacts on the Capital Markets

Propelled by broad market optimism and a favorable issuance environment, capital market activity across asset classes surged in 2021. However, momentum slowed in Q1 2022 amid a variety of headwinds. Will this pace continue? We asked recent webinar attendees what factors they were most concerned about in relation to capital markets activity. Gina Kashinsky, Managing Director, Equities Head of Global Markets Group at S&P Global Market Intelligence, asked Paul Gruenwald, Global Chief Economist at S&P Global Ratings, for his views.

Paul Gruenwald: The poll results line up pretty squarely with what my team has been thinking about and worrying about over the last couple of months, which is mainly an unexpected rise in inflation. Most central banks are finding themselves behind the curve, including the Fed. And the question now is whether they can bring inflation under control without causing a recession or even stagflation, which is the worse version of recession. Let’s think about how we got here and what's happening in the markets.

We started this year with a very positive outlook coming out of the pandemic. We had the U.S. and Europe both growing by more than 4% – 2x their potential growth – and a pretty good forecast for China, as well. But as we all know, the outbreak of the Russia-Ukraine conflict hit confidence worldwide and had a direct impact on food and fuel prices. We're seeing China struggle with its version of COVID and zero-COVID policy, and that's putting a damper on Chinese growth. And let's remember, China is the top driver of global activity and also gumming up supply chains.

What my team is really focusing on this year is the pace of interest rate normalization. I would draw a distinction between the U.S., where the Fed has a lot of work to do in our view; and Europe, where inflation remains more under control. But in both cases, the Central Bank is trying to guide the economy onto a path of 1.5-2% growth without seeing a big rise in the unemployment rates.

When central banks raise rates, that's supposed to do a couple of things. One is it will make borrowing more expensive, and that's going to have an impact on what we're talking about today, the capital markets. It's also meant to reduce asset prices, make people feel less wealthy, and strengthen the exchange rate.

All of those things are tapping the brakes on growth, but it's really a question of how fast this happens and whether we undershoot. We're going to know that in the next six months or so.

Gina Kashinsky: What are the steps that the Fed can take to prevent a potential recession in the coming weeks and months?

Paul Gruenwald: There are things the Fed can control, like domestic demand in the U.S., and there are things the Fed cannot control, such as what's going on with Russia, Ukraine, and China.

The Fed, as I said, is behind the curve, so they're going to have to do quite a bit of work. I think the key is to be really clear about what they're watching and to be really deliberate in signaling their actions. The Fed is going to have to raise rates, in our view, by 50 basis points in the next couple of meetings. If the rest of the world behaves – we can define that however we want – the Fed should be able to get the economy back on a sustainable path without a recession. We have about a 30% probability of recession in our baseline.

But given what's happening in Ukraine and the impulse from supply-generated inflation regarding food and fuel from abroad, we can say that, although it's not our baseline, the risk of a recession in the U.S. is continuing to rise.

Gina Kashinsky: To accurately gauge financial conditions, should we be looking at more than just the federal funds rate? How high does the Fed need to raise rates in order to get inflation under control?”

Paul Gruenwald: We as economists pay a lot of attention to the Fed funds rate. What economies do is broader and, I think, a bit more statistically robust. They look at financial conditions overall, including asset prices, spreads, level of interest rates, volatility, etc. The Chicago Fed, for example, has a great FCI index.

The reason I'm raising this is that those financial conditions have already tightened a lot more than the Fed has raised rates. The Fed has raised rates twice in 2022 by a total of 75 basis points. They're still well below the neutral rate, which we think is 2.5%. But the financial conditions that I just mentioned are already back to neutral and, on some measures, a little bit tight.

The overall financial conditions are what we should be watching for, as they’re sort of the market expression of interest rates. I think they're a better indicator. In terms of how high the Fed needs to go, well, that's been the big game. As I said, 2.5% for the fed funds rate is the estimate for neutral of most economists. Our view is that because the Fed started late, it's behind the curve. Any measure of inflation – including the PCE (personal consumption expenditure), which is the one Fed watches – is well above the 2% target. We think the Fed will have to go above 2.5%.

Our Chief U.S. Economist, Beth Ann Bovino, thinks they will get to 2.5% by the end of this year and probably go into the low to mid-3s. The trick around all of this is the lag. When the Central Bank moves, it takes two to four quarters for those rate hikes to filter their way through the economy. But right now, given where we are in the inflation story, it looks like the Fed is going to have to continue to go by 50 basis points, not 25 in their rate hikes. We see a couple of more 50s in the next two meetings, and they're going to have to go past neutral into the low-3s.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global. Statements made by persons who are not S&P Global Market Intelligence employees represent their own views, and are not necessarily the views of S&P Global Market Intelligence.