Fed policy tightening shifts into a faster gear as inflation remains hot

Current Situation

While headline real GDP growth moved into negative territory in the first quarter, core spending (consumer and business fixed investment) was solid over the period. This momentum carried into April with another robust month of hiring, positive retail sales growth, and further signs of expansion from the business sector. But high inflation persisted, driving the Fed to raise interest rates sharply in early May while adding to the negative sentiment trend for consumers and equity markets. Moreover, supply chains show only small signs of healing as the war in Ukraine and China lockdowns delay restocking of goods to extend inflationary pressures.

Future Outlook

The forward path for inflation and the Fed’s policy response continue to be the key factors for the outlook. While the extended war in Ukraine and renewed Covid-caused shutdowns in China add further stress for global production, the supply of inputs and goods should slowly improve as the year progresses and into 2023. This and the tightening of financial conditions by the Fed should act to slow inflation over the next year, albeit only slowly at first. But the risks that the Fed tightens so sharply over 2022-23 that the economy falters and heads into a downturn later in the forecast period are climbing, although the chances are still less than 50 percent.