The Federal Reserve will save the markets by cutting interest rates in the event of a recession
- The Fed may have to cut interest rates in 2023 if a deep recession occurs, according to JPMorgan.
- The move would be a change in the Fed’s stance, given that it raised interest rates significantly in 2022.
- JPMorgan’s Marko Kolanovic said potential interest rate cuts from the Federal Reserve would help support the stock market in the event of a sharp decline.
Just as quickly the Fed raised rates in 2022, it could have done the exact opposite in 2023 and cut rates, according to JPMorgan.
That’s if a deep recession materializes and corporate earnings plunge, JPMorgan’s Marko Kolanovic said in a note on Wednesday.
The Fed has been on track to raise interest rates so far this year, with another massive 75 basis point increase expected later today. That will push the fed funds rate into a range of 3.0% to 3.25% by the end of the day, a far cry from its 0% to 0.25% range at the beginning of the year.
By the end of 2022, current market expectations are that the fed funds rate will be in a range of 4% to 4.25% as Fed Chair Jerome Powell seeks to extinguish high inflation readings.
But raising interest rates takes time to flow through the economy, which means there is a continuing risk that the Federal Reserve is over-tightening as it focuses on lagging indicators while economic growth slows. None of that was lost on JPMorgan CEO Jimmy Dimon, who is due to testify before Congress later today.
“Many Americans are feeling the pain, and consumer confidence continues to decline. As these storm clouds form on the horizon, even the best and brightest economists are divided over whether it could develop into a major economic storm or something much less severe.” Damon said in prepared testimony.
The main factor to watch is whether the unemployment rate is starting to rise, having been consistently below the 4% mark since December. The rate recently increased to 3.7% in August from 3.5% in July.
“The decline in incomes could become even more significant if the unemployment rate starts to rise materially and a prolonged or deep recession occurs,” Kolanovic said. But such a scenario does not mean that investors should abandon stocks, because the Fed may return to its years-long practice of easing financial conditions, according to the note.
“But even in this opposite scenario, we believe that the Fed will cut interest rates by more than what is currently priced for 2023, thus supporting stock markets and achieving a price/earnings multiplier,” he added.
The market is currently pricing in if the Fed holds off on rate increases for most of 2023, with two potential 25 basis point rate cuts due at the end of next year. Ultimately, Kolanovic believes that these price cuts could accelerate dramatically if economic strength begins to deteriorate.
Kolanovic concluded that a market-friendly Fed likely in 2023, combined with lower investor positioning and lower long-term inflation expectations, suggest that the downside in the stock market is limited at current levels, even if a slowdown materializes next year.