Recession Odds Raised as the Federal Reserve Fights Inflation

The recently released data on the consumer price index suggests that inflation hasn’t been tamed, with “headline” rates remaining above 8%. The Federal Reserve met in June and raised the federal funds (short-term) rate by 0.75%; the strongest such move in 28 years. The thinking goes that the faster the Fed moves rates upward, reaching “terminal” pricing, the sooner inflation will be broken and the sooner the current problem will be behind us. 

Of course, the problem is that, the more rapidly the Fed moves, the higher the probability we will experience a recession. Remember, the Fed just moved into a QT (quantitative tightening) policy earlier this month, allowing $47.5 billion in bonds to mature without reinvestment per month, which, in effect, tightens monetary policy. In addition to the new QT actions, the rapid increase in rates only intensifies the monetary tightening mode. The Fed has become serious about fighting inflation. In my opinion, it is about time. 

Tightening, But Not Yet “Tight”

From both mathematical and theoretical standpoints, the Fed won’t be in a tight stance until the fed funds rate exceeds core “underlying” inflation pressure. I suggest underlying, core longer-term inflation will be 3.0%-3.5%. Consequently, even after the Fed increase of 75 basis points, the fed funds rate is 1.6%, well below “neutral” positioning and even further below a monetary tight position. The Fed is gearing up to reach neutral positioning, targeting a fed funds rate of 3.0% by the end of 2022. This outlook is in line with the Fed’s own “dot plot” outline.

So even after the Fed’s move, monetary policy will remain in accommodative territory and in need of further tightening to seriously alter inflation’s apparent track until later this year.

Real World Data Shows Growth and Inflation Stresses Building

On a real-world basis, the economy is already slowing rather dramatically. Wage growth rates have been 3.75% on average (annualized) over the last three months, down from 5.2% earlier this year.¹ Historically, sustainable inflation tends to eventually follow wage growth rates. On a core basis, inflation data regarding measurements of the CPI, PPI and PCE all suggest those rates are currently rolling over. 

So, are we seeing peak inflation currently? I don’t know, but I suggest we are getting close to that realization. Why? Growth stresses are starting to hit Main Street. As the growth in demand slows because of high prices, price acceleration starts to weaken. 

Along with the points from above, I suggest stresses on economic growth are starting to hit Main Street.

• According to Barron’s magazine, the Barron’s Basics CPI is up 17% year over year. This CPI indicator, which I have called the “core, core inflation rate,” is comprised of basic items that all households must buy including:

• Lower-income households that spend a large percentage of their take-home pay on the items above aren’t experiencing 8% inflation but are experiencing something much stronger than the headline numbers suggest.
• Seeing that the average worker’s income has increased by 5% over this period of time shows the necessities of life are 12% more expensive today,² after the cost increases of those items, compared to a year ago. 
• This is leading to many households having to dip into savings or incur an increased level of revolving (credit card) debt just to pay household bills. 
• This stress is starting to show up in retail sales and inventory build rates. Indeed, retail sales fell by 0.3% in May. After inflation, retail sales fell 1.3%,³ driven primarily by a significant slowing in auto sales.
• To top off this data, according to The Wall Street Journal, in recent interviews and public statements, Fed officials have sketched out a path in which unemployment rises this year, though not sharply, as inflation cools – a scenario Fed Chairman Powell has referred to as a “soft or soft-ish landing.” 
• This balancing act that the Fed is attempting to accomplish (a lowering of inflation pressure combined with a slowing in overall economic growth) is a rarity. We can look back in time and find that it is rare for the Fed to successfully engineer a soft landing after a period of strong inflation pressure. Who knows – perhaps the Fed will be able to pull the rabbit out of the hat this time around. 

With these stresses in mind, and with the Fed taking on a more aggressive inflation-fighting position, I am raising the probability that we will experience a recession this year from the previous 30% to the new 40% probability. I am lowering the probability of a soft landing as outlined above from 20% to a 10% probability. 

How do others view the probability of an upcoming economic contraction? The average economist’s outlook is calling for a 44% probability of recession in the next 12 months, up from a probability of 28%, which was registered in April.⁴ Indeed, recently the New York Federal Reserve stated that there is an 80% probability the economy will experience a “hard landing” over the next 12 months.⁵ And this from the organization that is driving rates higher.

My remaining 50% probability reflects an underlying stagflation environment in which inflation stays well above normal (3.7%), and growth remains well below normal (3.2%). By the end of this year, I suggest we will see inflation at 6% (year over year) and economic growth at 2.5% (year over year). Make no mistake, with the Fed’s monetary policies continuing to become more aggressive, the probability of an error, of the Fed moving too far too quickly, becomes a real risk.

Staying With Our Discipline

Turning to our 3-indictor discipline shows that:

• The 2/10-year Treasury yield curve, once again, inverted. While that inversion has gone away, the fact remains that the bond market yield curve inverted once again. However, the fed funds/10-year Treasury yield curve has yet to invert. On balance, this indicator is flashing “yellow” with a slight warning of an upcoming recession.
• The PMI indexes remain in decent territory but have contracted from their highs. This indicator is still in positive territory, suggesting no recession in sight. 
• The 6-month rate of change of the LEI (leading economic indicators) has now entered negative territory at -0.4%. Prior to previous recessions, the 6-month rate of change of the LEI has tended to be -3.0%. So, this indicator, like our yield curve indicator, is now flashing yellow.

From a discipline standpoint, it is still early to make a “slam-dunk” call of an upcoming recession. But we now have one indicator which has flashed “red” more than once, one other that is flashing trouble ahead and one that has deteriorated but is still in reasonable shape. The odds of an upcoming recession, by our discipline, have increased.    

These indicators represent strong enough reasons to suggest that a recession by the end of the year may not yet be our core call, but the indicators are meaningful enough for us to raise our recession probability to 40%. 

Macro Stresses on the Rise

Obviously, financial stresses are on the rise. Growth is slowing. Headline inflation remains strong. The housing market is showing signs of stress. Of course, the stock market has reentered “bear” territory, which, if prices stay low long enough, will bring a slowing, or contraction, in consumer consumption behavior.

Lower-income workers are experiencing stresses on income. If Fed policies lead to a softening in the labor market, real retracement in consumer spending activity may occur. If that happens, I suggest corporate investment spending may follow, all of which may lead to a recession. 

What of inflation? I believe the Fed will raise rates to terminal levels by the end of this year, which should start to slow overall inflation progress (along with economic growth rates). To truly get a handle on beating inflation, the Fed will need to pursue a tight policy, which I suggest will occur if the Fed raises the fed funds interest rate to 4% (I am targeting the Fed to raise the fed funds rate to 3% by the end of this year, up from the current 1.6%). I don’t believe the Fed will reach the 4% rate until 2023. When that occurs, the risk of an economic contraction will become real.

But the risks of a Fed-engineered downturn are escalating. As noted, I’m raising the probability of a recession occurring in 2022 to 40%. It is too early to make a definitive call for 2023, but I see clouds on the horizon. 

Sources:

¹Bureau of Labor Statistics

²Barron’s Article June 13, 2022 

³CNBC Report on Commerce Department News Release, June 13, 2022

⁴ Wall Street Journal article, June 21, 2022

⁵Wall Street Journal article, June 18, 2022

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