“The journey in between what you once were and who you are now becoming is where the dance of life takes place.” — Barbara De Angelis

All our life journeys are spent in different “rooms.” Early in life, we all spend time in the “childhood” room. Later, we spend time in the “student” room. Eventually, most of us spend time in the “parent” room. Most also spend time in the “working” room. As we move from one of life’s rooms to another, we go through a “passage” between rooms. The quote noted above from Barbara De Angelis reminds me of this time in life. 

These passages tend to be exciting but unsettling at the same time. During the passage, we notice our environment changing—be it good or disturbing. We eventually find our new room and make peace with our new surroundings. 

From a longer-term macro standpoint, I suggest the world’s economy is now going through a passage. Like life’s passages, the environment is different. We need to let go of the old room and embrace the new one. Such is the nature of life and economic passages.

What are the differences we will see between our old and new economic rooms? That, of course, is the question that we are all asking and will be discovering. I suggest the differences between the new and old rooms are many but may include:

• Our old economic room included very low inflation pressure. Some worried about deflation, which is a period of negative pricing power, and all the problems that brings. I suggest the days of deflationary pressure may be ending. 
• Our old room included increased economic globalization. This trend lifted the lives of literally billions of people, with “deep poverty” as defined by the World Bank declining at a rapid clip. The winners in this trend were many. Then again, there were economic losers as well.
• In our old room, the world’s central bankers were viewed as dependable “saviors” by capital markets. Toward the end of our stay in the old room, central bankers toyed with new economic concepts, including Modern Monetary Theory, which in the end was nothing but wishful thinking.

I have dubbed late 2022 & 2023 economic passage years, years when I expect the world’s economy to travel from one main theme, or environment, to another. This passageway has included higher inflation and lower GDP growth—the threat of old-fashioned stagflation. I suspect we will see the days of stagflation erode to eventually give way to a more sustainable and reasonable growth and inflation outcome. 

But getting from one economic environment to another, for the economy to move along the passageway to a new room may take some time as the economy experiences adjustment pains. We are going through a period of heightened uncertainty, where economic drivers are changing. During periods of rising uncertainty, people tend to retreat. I continue to believe a quick, light recession may be in the cards for 2023.   

Good and Bad News – All Changes

But all is not bad. At the end of this year, I expect to see inflation (core) to have fallen to an annualized 3% to 4% range from the 2022 level of 5.7%.¹ This level of inflation is in line with the long-term historical Consumer Price Index (CPI) rate of change.²

I also expect to see growth (GDP growth for the year) to be in the 1% to 2% range. If we experience a short, shallow recession, as I forecast, the passage we are now in will help cleanse the economy of high inflation pressures. While job losses may occur this year, my target for the unemployment rate is 5%, up from the current 3.7% level. This is not a disastrous jobs market outcome. 

As stated in last month’s commentary, on balance, over the longer-term, I expect our new economic room will provide higher economic growth and inflation than the room that we left behind. That said, let’s take a look at the inflation passage of late.

Inflation Update – Pressure Receding, as Expected

Lower inflation pressure and leaving behind the stagflation pressures we saw during 2021 to 2022 has already begun. Irrespective of how this is measured, inflation is becoming less of an economic headache.

Chart Source Data: St. Louis Federal Reserve

As we look at the data above, by comparing the trailing 12-month inflation rate with the three-month annualized data, we see the close-in inflation trend moving even lower. The three-month annualized core inflation (CPI) is 3.1% compared to the rolling 12-month print of 5.7%, indicating the more recent trend of inflation is declining. The same trend can be seen in the Personal Consumption Expenditure (PCE) data above, which is another measure of inflation—the measure that the Federal Reserve uses for its main gauge of inflation pressure.

Digging into recent inflation data also shows that goods inflation has receded, while services inflation remains higher. Services, such as restaurants and travel, tend to be more labor intensive than goods manufacturing, which tends to be more capital intensive. Due to a sticky labor market, hiring and retention costs for employees are high—more on this later.   

Getting back to the inflation data, as noted, inflation (core and headline, both CPI and PCE) is slowly reverting to its long-term average of 3% to 4%.³ As the high-inflation months of earlier in 2022 are further in the past, I think most inflation measures this year will continue to contract toward my target inflation rate of 3% to 4% on an annualized basis. While we are in an economic passageway, I suggest two main themes that I outlined last year are still in force. Those themes were: 

• “Flation” gives way to “stag” in a stagflation world. In other words, as economic growth rates slow, final demand levels also retreat, bringing inflation pressure down with them. 
• I have consistently suggested that 2022 will go down as a year of heightened financial risks, and 2023 will be a year when business risk is higher than normal. 

Inflation Taking on a New Hue?

As noted above, I outlined that the inflation we have experienced so far has been affected by supply/demand imbalances and irritated by the pandemic and government policies, which were applied in 2021 (both fiscal and monetary).

As the economy was recovering from the pandemic-driven downturn, the government stepped up its stimulus programs, driving final demand needlessly without consideration of the supply-side of the equation. The governmental actions were financially underwritten by the Fed, which maintained easy monetary policies throughout 2021. 

Inflation rates have receded, irrespective of which measure is used. This is outlined above. But I’m starting to get a sense that cost-push inflation may be on the horizon. I hope this isn’t the case, but I find the following data concerning. 

Worker compensation growth is the highest we have seen for quite some time. Unfortunately, worker productivity is the lowest over the same period.⁴ Consequently, unit labor costs at +6.4% are high. 

Many businesses have little choice but to raise prices because of rising unit labor costs—the definition of cost-push inflation, where unit costs are rising, and prices are pushed upward to maintain profitability. While the data noted above is preliminary and not yet a trend, the data is unsettling. 

The hyperinflation days of the late 1970s to the early 1980s was driven by cost-push inflation pressure. This type of inflation, if left unattended, can turn into a cycle, where higher unit costs drive prices higher, which drives worker wage demands higher, which drives prices higher… well, you get the picture. An inflation “spiral” might ensue.    

Money Supply Growth – To Impact GDP Growth?

While GDP growth has yet to reflect monetary tightening, it should by the middle of 2023. The Fed didn’t start raising rates and tightening monetary policy until March of 2022. Typically, Main Street doesn’t feel the full effects of monetary policy for six to 12 months following the tightening policy change. Typically, there is a lag between an interest rate rise and the full effect of that rise on final demand. Below find fed funds rate increases from last year:

Source:  St. Louis Fed. Money supply growth data is M2 growth for periods annualized. 

It is important to remember that the three-month annualized M2 growth rate was +10.0% at the beginning of 2022. From a monetary standpoint, the period of easy money helped salvage economic growth in 2022. The Fed has orchestrated an M2 growth contraction of 15% since the start of 2022. This is the sharpest downshift in money supply we have seen from the Fed in years. If one believes Milton Friedman’s work, one believes the quantity of money is a major driver of economic activity, with a lag.

Speaking of economic lags, I don’t believe economic growth will be fully affected by the Fed’s major, multiple 0.75% rate increases until sometime later in 2023. The economy is currently absorbing the first light 25 and 50 basis point moves that occurred earlier in 2022. Those who don’t think the economy’s growth rate will slow this year may also believe that monetary policies have little or nothing to do with economic activity. I tend to disagree with this assessment. While the Fed is no longer in full control of our current monetary environment (there are many ways money can be created or destroyed aside from the Fed’s policy levers), my view is Fed policies still matter. I am suggesting that we face a 50%+ probability of seeing a light recession sometime in 2023.

Final Word

Irrespective of a recession/no recession, I believe we are currently experiencing an economic transition or passageway. We are leaving the low/no inflation + low/no growth economic room and moving toward something different. I suggest the new room we are moving to may include higher sustained inflation and higher sustained economic growth than has been the case over the last 10 years or so. 

I also suggest interest rates will remain higher and competition for capital will be stronger. Perhaps not all ventures will find funding as easily as has been the case over the last decade. 

But those issues are for another day, after we arrive in our new room. Meanwhile, we walk through the passageway.

Sources:

¹Core CPI per the Bureau of Labor Statistics

^2,3St. Louis Federal Reserve

⁴ Data represents 10 years ending 2021 per the St. Louis Fed.

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