Ausforex Goldman Sachs: Fed's prolonged monetary tightening will weigh on markets and the economy

Oct. 10 - Goldman Sachs has warned that a longer period of higher interest rates by the Federal Reserve will weigh on the economy and markets. Strategists say this mainly means a long-term drag on GDP. Higher rates could also weigh on stocks and cause more pain for companies.

Goldman Sachs said that the Federal Reserve's prolonged tightening of monetary policy will weigh on markets and the economy for the foreseeable future.

Strategists led by Jan Hatzius pointed out in a report on Sunday (October 8) that persistently high inflation and strong economic data have clouded interest rate cut forecasts, and the so-called longer-term, higher interest rate regime could be a bigger drag on GDP than expected.

Some Federal Reserve officials have recently hinted that it may not be necessary to cut interest rates to avert a recession, and investors have had to reassess the level of interest rates they may maintain in the coming months.

"In the last cycle, the belief that real interest rates will remain near zero in the future helped to rationalise some of the major economic trends that had previously looked more problematic: higher valuations of risky assets in the financial marekt, the unexpected survival of companies in the corporate sector that continue to lose money, and the huge deficits that further add to the huge federal debt of the public sector," Goldman Sachs said.

Strategists now expect tighter financial conditions to reduce GDP growth by about half a percentage point over the next year, which will coincide with risks in asset markets.

However, in Goldman's opinion, this correction will not be as severe as last year, and it is still too small to cause a recession.Before the current rate hike cycle, interest rates were at historically low levels. In financial marekt, this meant investors justified high valuations that supported risky assets. In the corporate sector, low rates opened the door to financing for unprofitable companies looking to grow bigger in the future, Goldman Sachs noted.

However, the current market trend is changing.Strategists have warned that a sell-off could be imminent.

"The key risk at financial marekt is that interest rate-based valuation metrics are now higher for some assets, especially equities," the strategists wrote."We estimate that if equity risk premiums were to fall to the 50th percentage point on record, the impact on GDP growth over the following year would be 1 per cent. If they were to fall to the average of the years before the global financial crisis, the loss would be 0.75 percentage points."

At the same time, considering the higher opportunity cost, companies may face more hesitant investors, as well as those who are unwilling to finance unprofitable companies.

"This could force these firms to close or cut labour costs more aggressively, as they have tended to do in the past when they were hit by interest rates," Goldman said. "A 50 per cent increase in their exit rate would weigh on monthly employment growth by about 20,000 people and hit GDP growth by about 0.2 percentage points."

Finally, strategists say that in the public sector, real interest payments and federal debt-to-GDP ratios will be much worse than they were a few years ago.

"We believe that concerns about debt sustainability are unlikely to lead to a deficit reduction deal in the short term," strategists insist. "But if that does happen, a deal on a scale similar to the 1993 fiscal adjustment would mean a hit to GDP growth of up to 0.5 percentage points a year for several years."