Economic Outlook

• Inflation disappoints, holds at 8.3% in August
• Federal Reserve boosts rates another 0.75%, signals determination to quell inflation 
• Markets react negatively
• Probability of recession increasing

Although US employment remains strong, the rapid increase in Fed-imposed interest rates, historically high inflation, and ongoing supply chain issues are combining to restrict growth in the US to levels consistent with recession. The Fed is attempting to tamp down demand by increasing the cost of borrowing and tightening liquidity. However, demand is already at levels that have produced two quarters of negative real growth in 2022. The Fed seems to believe that further economic contraction may be required before economic forces combine to drive inflation back to the 2% level that it seeks. For some, the recession is already here. Others argue that unemployment is too low to consider this to be a recession, even though employment is a lagging indicator. Two facts are indisputable: real growth is much too low for a healthy economy, and inflation is much too high.  

A large part of the dilemma faced by monetary policymakers lies in the fact that the dominant characteristic of the current situation—high inflation—has not been primarily caused by excess demand. Instead, current high inflation is, in large part, the product of a series of supply shocks. The Russian invasion of Ukraine cut supplies of wheat, fertilizer, soybeans, and gas. The West’s response to that invasion cut off energy exports from Russia, leading to shortages that pushed gas and oil prices to new highs. Frequent COVID lockdowns in Chinese port cities constrained the flow of parts and finished goods from the world’s leading manufacturer. Our own experience with COVID and its lockdowns disrupted key elements of our domestic supply chains and negatively impacted participation in our domestic labor markets.  The result of downward pressures on supplies was higher prices and inflation.

Another contributor to the current inflation was the extraordinary policy response to the COVID pandemic. We certainly cannot begrudge assistance to those that needed it in the face of such an unusual threat. But the serial assistance and loan programs, coupled with an aggressively expansionary monetary policy at the Fed, had the effect of introducing trillions of new dollars into the economy at a time when real productivity was at a low. Total stimulus, including both fiscal and monetary actions, totaled as much as $5-7 trillion. From a monetary perspective, some part of the present high inflation must be attributed to the extraordinary expansion of the money supply at a time when productive growth could not absorb it. A classic cause of inflation is when the money supply expands faster than productive economic growth.

To address the current situation, the Fed has two primary tools: interest rates and “quantitative tightening.” Quantitative tightening is the reverse of “quantitative easing” and is the process of reducing the vast portfolio of bonds the Fed holds on its balance sheet in an effort to mop up excess cash in the financial system. It is using both tools aggressively. Currently, the Fed is allowing $60 billion in treasuries and $35 billion in agency bonds to mature without replacement, thereby reducing its holdings in bonds by those amounts. The process effectively removes that much cash each month from the money supply.  

Quantitative tightening could be effective in removing excess cash from the financial system, thereby removing one monetary driver of inflation. Higher interest rates can tamp down demand by making purchases and investments more expensive.  However, neither of these actions directly addresses the supply constraints responsible for so much of the current inflationary cycle. The Fed is using the tools that it has, even though those tools may be poorly adapted to fix the type of inflation from which we suffer. Because those tools may only indirectly address one of the root causes of the present inflation—supply constraints—they risk doing greater harm to overall growth than might otherwise be necessary. The Fed may be further limited by the nature of the data it is focused on. It is attaching considerable importance to lagging indicators such as the Consumer Price Index (CPI) and the unemployment rate. It rarely mentions leading indicators, such as durable goods orders or new building permits, which already suggest growth is decelerating.  

Policymakers often overshoot in both directions. Investors and business leaders should anticipate that the probabilities of recession have increased in recent weeks.
 

Overall employment increased by 315,000 in August. The rate of increase slowed from recent months, suggesting that labor demand may be attenuating slightly. Unemployment ticked up to 3.7% but did so for the “healthy” reason that more people reentered the workforce. The labor force increased by over three quarters of a million workers, most of whom were in the prime working ages of 25-54. Hourly earnings growth declined to 0.3% (MOM). Taken together, these figures offer some hope that increased labor participation might also dampen wage inflation. The labor market remains tight, and August only provides us with a single data point, but if the trends of modest payroll gains, increased participation, and lower wage increases persist, employment’s contribution to overall inflation may decline.

Inflation continues at a concerning rate and remains the central focus of policymakers. “All items” CPI declined to 8.3% in August from a high of 9.1% in June and 8.5% in July. However, “core” CPI (less food and energy) actually went up to 6.3% from 5.9% in July. Lower gasoline prices brought the “all items” measure down; new and used vehicles and services, including transportation services, pushed the core measure up. Inflation appears to be easing in the area of energy and commodities, but it has taken root in the many other areas of the economy, including food and services.

The Federal Open Market Committee (FOMC) met on August 20th and 21st and once again raised their target for short-term rates by 0.75%. The upper end of that target is now 3.25%. Short-term rates were essentially at zero last February. The Committee’s press release and the Chairman’s comments after the meeting removed any doubt that the Committee would persist on its tightening path until inflation comes down in a meaningful way. The Committee has two more meetings through the end of 2022, and while it is expected that they will increase rates at both of those meetings, their own forecast regarding rates suggests that at least one of those increases will be for 0.50%.

The yield curve is inverted, with the 2-year Treasury yielding 4.20% and the 10-year Treasury at 3.69% at this writing. Historically, an inverted yield curve has been a precursor to recession.

Markets responded negatively to the latest Fed increase, with the S&P 500 declining 6.4% so far in September and 22.9% so far this year. Steep and sudden rate increases impact markets in multiple ways. First, higher rates produce lower valuations when calculating the present value of a stream of earnings. Second, higher rates increase the cost of doing business for most commercial ventures and certainly increase the cost of any new investment by those firms. Third, as higher rates increase the value of the dollar relative to other currencies, global sales become more costly for foreign buyers, and foreign earnings are converted back to dollars at disadvantageous rates. Finally, if the higher rates do precipitate a recession, stock prices need to reflect the impact of such a recession on future earnings.

So far this year, corporate earnings have generally been positive, but these results are increasingly being reported with warnings from business leaders about the headwinds associated with inflation, the supply chain problems, and consumers squeezed by inflation. Overall earnings for the S&P 500 have been up, however, if you strip out profits from energy companies, much of the gain evaporates. The current price earnings ratio for the S&P 500 is 18.7, well below its recent spike above 30 but also above the long-term average of 16. So, stocks are cheaper than they have been in recent times but not yet truly cheap in absolute terms.  

Earnings, like so many other measures, are backward-looking. If some of the effects of higher rates and slower growth are still working their way through corporate earnings, there may be more downside before they support another bull run.  However, markets also try to anticipate economic developments well in advance, and if inflation starts to respond to this more restrictive environment in the coming months, we may also get through the worst of the current market adjustments over the next couple of quarters.