U.S. economy on solid path despite omicron

Despite a surge in Covid-19 infections driven by the omicron variant, strong economic conditions and inflation mean U.S. interest rates are still set to rise, says Moody’s Investors Service.

In a new report, the rating agency said strong consumer spending, tightening labour markets and high inflation indicate that U.S. monetary policy is currently “highly accommodative” and that interest rates are “deeply negative.”

“The backdrop of elevated inflation and a tight labour market strengthens the case for an earlier and faster normalization of monetary policy,” Moody’s said. “Indeed, notwithstanding the risks to growth posed by the omicron surge, the Fed is well placed to move to a neutral monetary stance starting in March 2022, and we now expect three U.S. interest rate hikes this year, compared with our November expectation of none until 2023.”

Additionally, a recent shift in signals out of the Fed indicate “broad support” for both a rate hike in March and a normalization of its balance sheet soon after the rate increase cycle begins, Moody’s noted.

While Covid-19 infections have risen quickly in the U.S., creating added uncertainty, “the economy is on a solid expansionary path that the current virus surge is unlikely to derail,” the report noted.

Moody’s continues to expect that GDP will grow by 4.4% this year after rising by 5.4% in 2021.

“The surge in virus cases will no doubt dampen economic activity in pandemic-sensitive services industries in January but, as previous virus surges have shown, activity will rebound once the omicron wave begins to subside,” Moody’s said.

The report noted that latest epidemiological forecasts point to a peak in case counts by the end of the month, with hospitalizations and fatalities peaking in mid-February.

Inflation is expected to moderate this year, but Moody’s said there remains a good deal of uncertainty in inflation forecasts.

“We expect that the Fed will provide more concrete guidance at its next January meeting as to when and at what pace it will begin to raise the federal funds rate and reduce the size of its balance sheet,” it said.

The rating agency noted that it expects the Fed to take a “measured approach” to withdrawing stimulus and normalizing its balance sheet, given the elevated uncertainty in forecasts and a likely reluctance to move too quickly.

Ultimately though, the prospect of rate hikes and balance sheet normalization “will likely push both short-term rates and long-term yields upward,” Moody’s said.

“The effect of rising rates is likely to be transmitted to the real sector by curbing new lending for consumer goods, autos and homes. Small and mid-size firms, which tend to have shorter debt maturity profiles, will also be affected,” it said. “Lastly, higher interest rates will weigh on the valuations of risky assets.”

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.