Author Details

Andy Sparks

Andy Sparks

Managing Director, MSCI Research

Tamas Hanis

Tamas Hanis

Vice President, MSCI Research

Edina Szirmai

Edina Szirmai

Vice President, MSCI Research

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Three Scenarios for Fed Policy, Inflation and Growth

  • Recent encouraging U.S. inflation data was not enough to soften Federal Reserve Chair Jay Powell’s tough talk on inflation following this week’s Federal Open Market Committee meeting.
  • Inflation, economic growth and the effectiveness of monetary policy continue to be primary uncertainties facing investors.
  • We consider three scenarios and their impact on a diversified portfolio: sticky inflation, a soft landing and global recession. In the worst-case scenario of global recession, a composite portfolio could lose as much as 11%.

The U.S. consumer price index (CPI) for November showed unexpectedly low inflation across goods and services and suggests that the previous report showing low inflation in October was not an anomaly. Combined with ongoing labor-market strength, this recent inflation data supports the view that the Federal Reserve’s hoped-for soft landing has a plausible chance of succeeding.

At the press conference following the Federal Open Market Committee (FOMC) meeting, Federal Reserve Chair Jay Powell resisted the temptation to focus on the good inflation news. Instead, he emphasized that the Fed needs to see substantially more evidence that inflation is headed toward the central bank’s 2% goal before the Fed may consider a less restrictive rate policy.

Chair Powell’s remarks may open the Fed up to more criticism from doves, who may argue that the Fed has overreacted and is pushing the economy into recession with its overaggressive policies.


Navigating the uncertainty with scenario analysis

With these uncertainties in mind, we consider three scenarios for the U.S. economy and analyze their impact on diversified portfolios:

  • Sticky inflation: U.S. inflation remains stubbornly high, forcing the Fed to increase the pace of rate hikes and raise the terminal policy rate from 5% to 6%. The U.S. dollar appreciates, while U.S. Treasurys, equities and credit experience losses.
  • Soft landing: The Fed’s current rate policy successfully brings U.S. inflation down without significantly impacting the real economy. The U.S. dollar depreciates; global equities and credit rally. Since the Fed keeps to its priced-in rate-hike path, U.S. Treasurys remain mostly flat.
  • Global recession: Inflation slows down significantly, and the global economy enters a recession. The Fed and other central banks reverse their rate policies. The U.S. dollar depreciates, whereby the impact of collapsing rate differentials outweighs the effect of the U.S. dollar’s safe-haven status. U.S. and European equities sell off, as corporate earnings decrease, while government-bond markets rally due to falling rates.


What we assume in our scenarios

  Sticky inflation Soft landing Global recession
Nominal yields USD 2Y rate: +100
basis points (bps)
USD 10Y rate: +50 bps
USD 2Y rate: flat
USD 10Y rate: -10 bps
USD 2Y rate: -250 bps
USD 10Y rate: -100 bps
Equity U.S. equity: -10%
European equity: -10%
U.S. equity: +15%
European equity: +20%
U.S. equity: -25%
European equity: -20%
USDEUR +5% -5% -10%
U.S. breakeven
inflation (BEI)
2Y BEI: +100 bps 2Y BEI: -50 bps 2Y BEI: -200 bps
U.S. investment-
grade and high-
yield corporate
IG: +50 bps
HY: +150 bps
IG: -50 bps
HY: -100 bps
IG: +100 bps
HY: +400 bps
Oil flat -5% -40%

The shocks are informed by analysis of historical market data, external market commentary and the MSCI Macro-Finance Model. These are not forecasts but hypothetical narratives of how the various scenarios could affect portfolios. It may take time (up to several months) for the shocks in these scenarios to materialize.


Potential impact of the hypothetical scenarios

The scenarios’ impact is calculated by applying MSCI’s predictive stress-testing framework to a hypothetical portfolio consisting of global equities, U.S. bonds and real estate.1 This diversified composite portfolio could gain 10% in our soft-landing scenario while it could lose up to 11% in our worst-case global-recession scenario. The sticky-inflation scenario is in between, with a portfolio loss of around 8%.


What our scenarios imply for global portfolios


Portfolio impact of the scenarios based on market data as of Dec. 9, 2022. U.S. Treasurys, Treasury inflation-protected securities and EU and Asia-Pacific sovereign bonds are represented by Markit iBoxx indexes. Equities and corporate bonds are represented by MSCI indexes. Private equity is represented by model portfolios. U.S. real estate is represented by the MSCI/PREA U.S. AFOE Quarterly Property Fund Index. The composite portfolio is 50% global equities (35% public and 15% private), 10% U.S. Treasurys, 10% U.S. Treasury inflation-protected securities, 10% U.S. investment-grade bonds, 10% U.S. high-yield bonds and 10% U.S. real estate. Composite corporate-bond portfolios are 85% investment-grade bonds and 15% high-yield bonds. Source: S&P Global Market Intelligence, MSCI


Concluding remarks

The outlook ahead depends crucially on economic growth, the nature of today’s inflation and the Fed’s response. Recent low inflation may raise hopes of a soft landing, but could also reflect a Fed that has been overaggressive and is pushing the global economy into recession. Investors may find it useful to analyze their portfolios under different assumed scenarios given the abundance of uncertainty in today’s market environment.


The authors thank Will Baker for his contributions to this blog post.



1The results are generated by using model correlations to propagate shocks to the portfolios, using MSCI's BarraOne®. MSCI clients can access BarraOne® and RiskMetrics® RiskManager® files for these scenarios on the client-support site.



Further Reading

Inflation, the Fed and the Rocky Road Ahead

The Fed Post-Election: Inflation Still the Focus