Where Is the U.S. Economy Headed? Three Possible Scenarios

April 7, 2022
Where is the U.S. Economy Headed? Three Possible Scenarios

Many remain concerned about the path of the U.S. economy and subsequently, the U.S. stock market. While it remains my “core” outlook theme, I have recently lowered the probability of the “return to normalcy” economic environment to 40% this year. That economic scenario is calling for gross domestic product (GDP) growth and inflation pressure to shrink as the year unfolds to 2.5% expected economic growth (“real” GDP growth) and 4% year-over-year inflation by the end of 2022. 

The other 60% probability is shared between a focus on a “stagflation” environment and an outright economic recession. In my outlook, I am suggesting a period of stagflation is a combination of slower-than-normal growth combined with higher-than-normal inflation pressure. This view suggests economic growth of less than 2.5% and inflation higher than 4%. I have assigned a 40% probability to stagflation being the main driver of economic activity this year. 

I suggest of the three probabilities, recession remains the outlier, at 20% probability. According to the folks at the NBER (National Bureau of Economic Research), which is responsible for calling recessions, the U.S. has been in recession 12% of the time since the end of World War II. So, while a recession call is the lowest probability in our outlook this year, we think the probability of a recession unfolding later this year is higher than normal. 

The optimists who read this may highlight the prospect that in both the “return to normalcy” combined with the stagflation, possible outcomes total 80% probability that the U.S. economy shows growth this year. I think that is a rational expectation. 

The Federal Reserve Finally Moves Monetary Policy

As noted, I think the economy will grow this year, with the real wild card being inflation pressure. The higher the inflation, we should expect lower overall economic growth. Of course, the Fed has announced its intention of raising interest rates this year and have already started down that path. The Fed released its outlook in March, which addressed an outlook for short-term interest rates, GDP growth and inflation rates: 

As noted above, our “return to normalcy” view is calling for GDP growth this year of 2.5% with inflation of 4.0% (all-in CPI). The Fed uses the Personal Consumption Expenditures (PCE) Index as its inflation proxy. The Fed is looking for “nominal” GDP growth of 7.1% in 2022; decelerating to 4.9% in 2023. We are expecting nominal GDP of 6.5% this year, slightly lower, but within shouting distance of the Fed’s view. We concur with the Fed’s view that nominal GDP growth will decelerate this year from more than 10% last year, to approximately 6% to 7%.

In its announcement, the Fed lowered its expected “real” GDP growth expectation from 4.0% to 2.8% (a major recognition that the economy was leaving a hyper-growth environment), and raised the inflation expectation from 2.6% to 4.3%, a recognition that inflation isn’t “transitory” in nature. In describing inflation pressure last year, the Fed consistently used the word “transitory” to describe the sustainable of inflation pressure. That word wasn’t used in its current release.   

The Fed’s announcement was a recognition that its prime focus had shifted from creating “full employment” to battling inflation pressure. This is a big deal. The Fed has announced its current intentions to raise rates six more steps this year and four times next year. If each of these steps is 0.25% in size, we can expect the Fed Funds rate to trade at 2.9% by the end of 2023. We have been calling for the Fed to raise rates this year, so we say “it’s about time” in the Fed’s announcement. Of course, the Fed’s moves all directly impact primarily short-term interest rates.

Lastly, the Fed didn’t announce any concrete view as to the long-awaited actions of reducing the size of its balance sheet. We are anticipating the Fed to start this process sometime later this year. When that happens, upside pressure on longer-term interest rates may start to accelerate. Indeed, 30-year fixed mortgage rates have already been rising rather dramatically. At the first of the year, the national average 30-year home mortgage rate was 3.11%. Now, that rate has risen to 4.67%.1 Per a standard mortgage calculator, the rise in rates has increased the monthly cost of a 30-year mortgage by 20%, all in three months.    

To say interest rate increases are starting to affect consumer behavior is probably an understatement. I suggest mortgage rates will continue to work their way higher as the year unfolds.

Back to the Economic Outlook – What Tightening Fed Monetary Policy Means 

Many investors haven’t faced an unfriendly Fed policy. Why worry about the Fed raising rates? Typically, after the Fed starts to raise rates, the economy could fall into recession, if rates are increased enough. This negative outcome takes time to unfold but doesn’t always occur. Will the Fed’s actions slow inflation while keeping the economy out of recession? The Fed has engineered three “soft landings” through its tightening policies in the past, but those three occasions occurred when inflation was much lower and less of a problem than it is today. We suggest the risk of an upcoming recession is higher than normal. 

As the Fed increases interest rates, these policies impact the overall economic environment in several ways. To sort this out, think of Fed policy and the creation of money as the oil in the engine of your automobile. If your engine has a full measure of oil, it runs smoothly, as the oil acts as a lubricant to all the moving parts. 

As oil is taken out of the engine block, friction starts to occur, wearing the engine’s internal parts which, if it lasts too long, will lead to real engine performance problems. Money growth, like oil levels in your car, is the “lubricant” which makes things work smoothly. The Fed has signaled that it intends to slow overall money growth rates, effectively taking “oil” out of the engine.

Now that the Fed is raising interest rates in its attempt to address the inflation problem, M2 (economic lubricant levels) growth will start to subside. Money multipliers will start to shrink. The Fed has telegraphed it expects to raise the Federal Funds rate to 1.9% by the end of this year, and to 2.9% by the end of 2023. 

We suggest inflation might run at a “sustainable” 2.5% to 3.0% level over the longer term, (and about 4% this year), and “real” economic growth running at 2.5% (both core longer-term views). The Fed’s policy of raising interest rates to 2.75% isn’t “restrictive” and won’t occur until short-term rates are sustainably higher than inflation. If my longer-term outlook is rational, eventually the Fed will need to become “restrictive” to tame the rising inflation beast. We suggest it will need to raise rates above its currently telegraphed 2.9%.      

Some would now ask – if we are expecting the Fed’s policy to restrain overall economic growth this year, why are we carrying a 20% recession probability for 2022? Why not higher? Our long-proven warning signals of an upcoming recession are not yet flashing “red.” Two of our three indicators are still flashing “green,” while one is now flashing “yellow” (shape of yield curve, as the interest rate “spread” between the 2- and 10-year Treasury notes, is now very low). Perhaps recession concerns will become more intense in 2023. 

A quick note on the 2- to 10-year Treasury yield spread is appropriate. While many are making note of the spread between these two interest rates, I put more credence in the spread between Fed Funds and the 10-year note. Why does it make sense to observe this yield spread instead of the 2- to 10-year Treasury yield spread? For two reasons: first, this spread is part of the official “leading economic indicators” while the 2- to 10-year spread is not; secondly, the Fed Funds rate is directly controlled by the Fed while the 2-year Treasury yield is influenced by many other factors. Why is it important for us to use a rate directly controlled by the Fed?

Federal Funds Rate Actual vs Futures

We are looking for clues as to a mistake, which the Fed may be making (becoming too tight), an error in judgement, if you will.  I suggest that most recessions in the past have been influenced (some say “caused”) by an error in Fed policy – that the bank is running policies that are too restrictive. The Fed Funds rate against the 10-year Treasury yield is a good indicator that the Fed is either too loose (leading eventually to an upward push in inflation as we are now seeing) or too tight (leading to a recession). The yield on the 2-year Treasury may give a false reading of the Fed’s actual policy on overall financial conditions. 

As noted above, the yield spread between Fed Funds rate and the 10-year Treasury is still rather steep.

It is true that, historically, the Fed Funds rate has tracked (with a lag) the yield on the 2-year Treasury, as noted in the chart above, with the Fed Funds rate indicated by the red line, and the 2-year Treasury yield as noted by the blue line. This analysis leads to the conclusion that the Fed Funds rate is headed higher, which of course the Fed has announced their plans as such. 

So, watch both the 2- to 10-year and the Fed Funds rate—10-year Treasury yield spreads—to give indications of rising recession risks. While the 2- to 10-year rate is indicating an increase in upcoming recession risk, the Fed Funds rate 10-year spread is not yet suggesting a recession is eminent. 

A last note on this subject. When a yield curve inversion has taken place in the past, a recession is normally 12 to 18 months away. Yield spread inversions are typically not a “coincident” indicator, but rather a forward-looking indicator. Also, neither of the other two indicators we use in our recession-watch process are indicating a recession is eminent. Our bottom line—we believe the yield curve recession-watch indicator is now flashing yellow and not red. Again, it is one of three indicators that we use. The other two indicators are still flashing green.     

Inflation is lighting your money on fire at a record pace.

What investments can help battle inflation?

Download Inflation: Hedge Strategies to Combat its Effects to learn more.

Final Word

We suggest with the Fed starting to raise interest rates, the macro-environment will lead to an increased level of investment funding selectivity. When the Fed is throwing massive amounts of liquidity into the system, as it has been doing for a period, investors tend to fund all needs and uses of cash. As the Fed starts to tighten the creation of liquidity, these funding levels tend to contract. This increases the level of scrutiny investors use when placing risk capital, which creates volatility in various asset class pricing.

When that excess capital vanishes, it starts to become obvious which investments are worthy of funding and which aren’t. The Fed’s announced actions will start the process of draining excess liquidity from the system. While an outright economic recession may be some time off, investors should expect at times to witness rather high levels of pricing volatility in various asset prices. 

Footnote

1Freddie Mac data

The Personal Consumption Expenditures (PCE) Index  is a United States-wide indicator of the average increase in prices for all domestic personal consumption. 

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