Investors are waking up to the harsh reality of just how much pain the economy may have to endure as the Federal Reserve continues its fight against stubbornly high inflation.
The Fed darkened its tone at last week's policy meeting, warning of serious economic hardship ahead, and markets finally took the central bank at its word.
The S&P 500, already in a bear market, experienced another major downswing on Friday. The Dow fell briefly into bear territory and closed at its lowest level since 2020.
But while investors have waivered between whether the Fed will achieve a "hard" or "soft" landing, there's a third, in-between possibility where everything feels kind of bad for a prolonged period of time. At this point, that economic purgatory may be investors' best hope.
What's happening: The Fed has had the same goal since it began hiking interest rates to fight inflation in March. It wants to achieve a soft landing — that Goldilocks ideal of cooling the economy enough to bring down prices but not enough to cause a recession. But the idea has grown increasingly untenable as inflation rates remain stubbornly high while economic data softens.
The new aim appears to be for a so-called growth recession: A prolonged period of meager growth and rising unemployment. The pain is sharper and lasts longer than that of a soft landing, but a "growth" recession doesn't pull the entire economy into contraction the way a proper recession would. It looks like a recession, and feels like a recession, but it isn't a recession — at least not officially.
The central bank's updated economic projections last week showed that it expects to land in this scenario. Policymakers revised down their forecasts for economic output through the end of 2024 and raised forecasts for the unemployment rate from their last projections published in June.
Last week, Fed Chair Jerome Powell acknowledged that the dream of a soft-landing is over. "Reducing inflation is likely to require a sustained period of below-trend growth," the chair said after announcing another three-quarters of a percentage point interest rate hike. There "will very likely be some softening of labor-market conditions," he added.
A growth recession is still painful. In a best-case scenario, said Joe Brusuelas, chief economist at RSM US, between five and six million US jobs would have to be lost to bring inflation down to the Fed's 2% goal.
The declaration of the recession might just be an academic exercise anyway, said Kevin Gordon, senior investment research manager at Charles Schwab, as people are already suffering economically. Low-income Americans are experiencing negative real wage growth, investors are losing serious money across multiple asset classes, homebuyers are being shut out of a housing market that's too expensive and renters are struggling to afford their leases.
The bottom line: Elevated housing prices, aching tech stocks, hot inflation and war in Europe are weighing on investors. The Federal Reserve's new warning that it isn't afraid to spark economic pain adds to the noise. Goldman Sachs and Bank of America both downgraded their annual S&P 500 targets last week.
"We can expect continued market turbulence for some time," said Brad McMillan, chief investment officer for Commonwealth Financial Network.
But there is a silver lining. "The Fed is performing surgery right now on the economy," said McMillan. "In the short run, it is painful. But in the long run? It is a healing process and one that sets the stage for a healthier economy and markets."
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