A line in the Sand on inflation
The phrase “drawing a line in the sand” has an unhappy history. In the U.S., it is said to have originated with Colonel William B. Travis, who drew a line in the sand at the Alamo declaring his willingness to fight and die rather than surrender. In 2008, following the takeover of Bear Stearns earlier that year, federal authorities drew a line in the sand and let Lehman Brothers go bankrupt. And in recent weeks, Fed officials have seemed to draw a line in the sand on inflation.
The President of the Minneapolis Fed, Neel Kashkari declared that “We need to get inflation down urgently” even though he didn’t know whether that could be achieved without sending the economy into recession. Cleveland Fed President, Loretta Mester said that the Fed needs to raise the federal funds rate to a little above 4% and thought a 75-basis point increase in September was not “unreasonable”. And, in an interview with the Wall Street Journal, St. Louis Fed President, James Bullard opined that it was important to raise the federal funds rate to a range of 3.75% to 4.00% by year-end, which would imply another 1.50% across the next three FOMC meetings.
This week we could get another dose of tough talk on inflation at the Federal Reserve’s annual retreat at Jackson Hole, Wyoming, with Fed Chairman Jerome Powell set to address the conference on Friday Morning at 10:00AM Eastern.
The Chairman will undoubtedly emphasize that inflation is too high and that the Fed is determined to bring it back down to its 2% target, even at the risk of economic weakness. He will also likely repeat that the Fed is not on a preset course and that their actions will be data dependent. However, his speech, echoing many of his colleagues in recent days, may well express confidence that the economy can handle higher rates and that, even with recently falling gasoline prices, it is far too early to declare victory in the war on inflation.
This is true. However, a balanced assessment of today’s economic environment suggests the danger of recession exceeds the risk of inflation staying at a level that could inflict long-term economic damage. If the Fed recognizes this in the next few weeks, they will moderate the pace of monetary tightening, potentially giving a further boost to U.S. bond and stock markets. If they do not, then interest rates could be higher in the short run but probably lower next year. The ultimate destination is likely the same either way – a slow-growing economy with moderate inflation and interest rates. However, the more volatile economic and market cycle that could be unleashed by an overly aggressive Federal Reserve could lead to a further near-term reassessment of valuations that would likely favor value over growth and, by ultimately sinking the U.S. dollar, favor international over U.S. equities.
The continuing recession risk
The July employment report, showing the creation of 528,000 new jobs, has given many the impression that the economy has dodged a recessionary bullet. While real GDP growth was negative in both the first and second quarters, the second quarter number is likely to be revised upwards this week and an early read on third-quarter GDP suggests a modest positive bounce. Our own models show 1.1% annualized real GDP growth in the third quarter while the Atlanta Fed’s GDPNow model is pointing to a 1.6% gain.
However, massive braking power is still being applied to the U.S. economy.
While real consumer spending rose by 1.8% over the past four quarters, this was only achieved by a decline in the personal savings rate from 10.9% to 5.2%. 5.2% is well below the 7.4% average seen in the five years before the pandemic, suggesting that many families are quickly racking up debt to pay for higher food and energy prices and rising rents. This situation will likely get worse for many younger households if, as expected, forbearance on federal student loans comes to an end on August 31st, (although the Biden Administration is likely to offer some partial relief). Even with solid wage gains, consumer spending is likely to grow very slowly if at all in upcoming quarters.
Homebuilding is likely to fall steadily over the next year as mortgage rates of over 5%, combined with a sharp increase in home prices over the pandemic, have boosted monthly mortgage payments on new homes by roughly 50% over the past year. This slowdown was clear in last week’s housing starts numbers and should also be evident in new home sales on Tuesday.
Business fixed investment could be a bright spot in the economy as companies invest in labor-saving equipment and energy infrastructure. However, recession fears and the current sharp deceleration in earnings growth could reduce capital spending momentum. Inventories will also have to grow more slowly in the year ahead as post-pandemic restocking fades.
The U.S. trade position should deteriorate further, reflecting an almost 17% year-over-year increase in the trade-weighted dollar and slower economic growth in Canada, Mexico, Europe and China.
Government spending could, in theory, be a bright spot as state and local governments have, on aggregate, run significant budget surpluses over the past year and the federal budget deficit is now down more than 70% year-over-year. However, none of the legislation passed in the last few months at the federal level amounts to fiscal stimulus and state and local governments appear unwilling to boost wage rates enough to fill vacant positions. It is notable that, while private sector employment is now 628,000 higher than before the pandemic, government employment is 597,000 lower.
Adding up the pieces suggests that there is a significant risk that the economy sees one or more additional quarters of negative real GDP growth in late 2022 or 2023. Moreover, we expect unfilled job openings to decline sharply in the months ahead so the next time real GDP turns negative, economists may not be able to point to booming job growth in denying that the economy is in recession.
A slower slide in inflation
While it is also too early to declare victory on inflation, there are good reasons to believe that it will continue to cool.
The July CPI report was a good first step with overall consumer prices remaining unchanged month-to-month following a 1% gain in May and a 1.3% rise in June. These numbers should be echoed by similarly mild readings in the PCE deflator readings due out on Friday.
The outlook for August CPI also looks good, with a very steady, continued decline in gasoline prices and industry reports showing lower airline fares, hotel rates and used vehicle prices. These factors on their own should be enough to generate a second consecutive very mild CPI report.
Thereafter, the story could turn more mixed for a few months as higher natural gas prices feed through to higher electricity prices, higher wages put cost pressures on businesses and high home prices continue to pressure rents. However, as we move into 2023, the trend towards lower inflation should resume. A squeeze on consumer spending should reduce price pressures across the board and there are clear signs that supply constraints caused by the pandemic are beginning to clear. In a slow-growing or recessionary economy it will be hard for inflation expectations to gain a foothold and wage growth should diminish as worker fears turn from the cost of living to the security of their employment.
The problem with lines in the sand
The bottom line is that the Federal Reserve’s current forecast that consumption deflator inflation will fall from roughly 6.5% year-over-year in July to 5.2% in the fourth quarter of 2022 and 2.6% in the fourth quarter of 2023 still looks very reasonable even if the economy avoids recession.
But avoiding recession is an important goal on its own. It’s important because of the hardship that rising unemployment inflicts on all of society but particularly those with the least resources to fall back on if they are laid off. It’s important because, after the trauma of the pandemic, a period of economic normality is sorely needed. And it is also important because the Federal Reserve does need to return real interest rates to positive levels for the long run, allowing for a more efficient use of capital throughout the economy. However, if they try to get there too quickly, and thereby trigger a recession, they will end up reversing course in 2023, returning rates to levels that have contributed to multiple asset bubbles in recent decades.
In 2008, just days after drawing a line in the sand on Lehman Brothers, federal authorities reversed course and organized a rescue of AIG. But by then it was too late to avoid the great financial crisis. The problem with drawing a line in the sand is that the sand has a habit of disappearing beneath your feet soon after you have drawn it.
For investors, it will be important to both listen to the Fed’s message this week and keep a close eye on the data. On balance, it still looks likely that the data will be weak enough on both growth and inflation to allow the Fed to raise rates by 50 rather than 75 basis points on September 21st.
However, if they back up their recent tough talk with tough actions next month, it may be wise to adopt a more diversified and defensive position in portfolios for the months ahead.
For more of my insights, listen to my Insights Now podcast for a breakdown on big ideas, future trends and their investment implications.
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Chief Global Strategist at J.P. Morgan Asset Management
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