We are on the downside of this business cycle, whether it ends up being designated a recession or not. The important questions are how long it will last and how bad it will get. There are sound reasons to believe that the U.S. economy will not crash like it did during the financial crisis. But this resilience suggests that the Fed will need to maintain a restrictive policy for many months, implying that a weak economy and difficult financial markets are likely to be with us for some time, possibly through next year.
How We Got Here
It is no surprise that we are in this situation. Government stimulus—fiscal and monetary—was far greater during the pandemic than any seen in modern history. Extraordinary support was necessary to avoid a disastrous economic and market outcome, but it turned out to be excessive. The U.S. government spent more than $5 trillion (~ 25 percent of GDP), more than seven times what was doled out during the financial crisis. The Fed bought nearly $5 trillion in bonds over the span of only two years compared with $3.5 trillion over six years during and after the financial crisis. This resulted in a rising tide of income and financial market liquidity that lifted all boats: from stocks to bonds to houses to commodities and finally to consumer price inflation, which has reached levels not seen in 40 years.
We were going to have to pay for all this largess at some point and have already experienced a significant fiscal tightening simply due to the expiration of the many COVID relief programs. It was always just a matter of time before the Fed was going to lift rates from zero and end its bond-buying program.
The payback we are now experiencing could have been shorter and less painful had the Fed recognized the inflation problem earlier. It began to accelerate at the start of last year and by the fall there were ample signs that inflation wasn’t coming down, yet the Fed kept rates at zero and continued buying bonds until March of this year. Along with other central banks around the world, the Fed did not adhere to the adage of “taking the punch bowl away just as the party was getting going.” As a result, they are now pursuing procyclical policies: tightening even as their economies are slowing.
The U.S. Is Holding Up Well Amidst a Sharp Global Slowdown
Combined with the effects of the war in Ukraine and ongoing COVID issues (particularly in China), tighter fiscal and monetary policies are producing a pronounced global economic slowdown and cratering financial markets. While the U.S. economy has slowed significantly, it is holding up remarkably well considering the many headwinds. Along with weaker global demand and a huge fiscal drag, interest rates, energy prices and the U.S. dollar have all risen sharply since the beginning of this year.
The resilience of the U.S. economy reflects several factors:
- The U.S. is the world’s biggest producer of food and energy, thus better insulated from the war in Ukraine.
- Excess demand for labor has fostered strong growth in employment even with zero GDP growth.
- The sharp drop in gasoline prices since mid-June has bolstered household purchasing power.
Things are likely to get worse before they get better however, due to more restraint in the pipeline. The expected Fed policy rate for yearend was 3.5 percent in late August and is now over 4 percent. Bond yields have soared, and 30-year fixed mortgage rates are now around 7 percent (up from 3.25 at the start of the year). The dollar has moved up further over the past couple of months, which will continue to make exports more expensive and imports cheaper. Finally, the sectors most sensitive to interest rate hikes and already in decline – housing and non-essential retail goods – don’t appear to have bottomed yet, and there are other sectors (mainly in services) that tend to be laggards.
U.S. Inflation Has Peaked and Is Heading Down
There is an upside to the slowdown: Inflation is now falling in the United States. Headline CPI and PCE inflation both have been consistently below their June peaks. While the Fed targets core inflation, headline inflation is what matters most to households since food and energy are staples in everyone’s budget and the most visible prices.
Much of the deceleration in U.S. inflation is due to the turnaround in energy prices, which are heavily influenced by geopolitical factors. But there are compelling signs that inflation is also heading down outside of energy. Inflation for goods has peaked and a decline is underway. The prices that producers are paying for their inputs have decelerated significantly, with the prices of intermediate goods—those used to process finished goods—now falling after having accelerated to a nearly 40 percent annual pace (on a 3-month basis) toward the end of last year. Price declines are already evident over a wide range of important inputs to goods production, ranging from lumber to copper to steel.
The turnaround in goods prices reflects both easing global supply chains and shifting consumer spending patterns. Delivery times in purchasing managers indices—a measure of supply bottlenecks—as well as the cost of shipping goods globally have both declined sharply. US consumer spending on goods has been falling since early summer, coming off the pandemic surge when the government doled out trillions of dollars in income support just as people had stopped spending money on services such as travel, entertainment, and going out to restaurants, gyms, and spas. Now we are on the reverse side of that shift as people reengage in services previously off limits.
Inflation in services has been accelerating as service industries move back toward full capacity. But there are early signs that services prices are beginning to turn down as well, although it will probably not show up in the data for several months. In particular, the cost of shelter (housing less utilities and furnishings) is starting to give way. Shelter costs dominate inflation in services, and the housing industry is already in recession as mortgage rates have doubled and real household income is falling. Existing home sales have plunged since the start of the year (-26 percent through August). Home prices began to fall in July for the first time in over a decade, although official measures of shelter costs look solely at rents. Brokerage listing indices show that rents have begun to drop as well, but inflation measures don’t capture changes on a timely basis. As a result, the recent declines in housing costs are unlikely to probably won’t show up in the inflation measures for at least several more months.
The Fed Is Likely to Go on Hold for an Extended Period Early Next Year
A key question for markets is what the Fed makes of all this. It engineered a dramatic shift in its policy and rhetoric over the summer. After maintaining that inflation was temporary through early this year, the Fed has hiked rates at the fastest pace since the 1980’s. The 75-bps rate hike at its most recent meeting was not a surprise, but Fed Chairman Powell’s statements afterwards and the FOMC forecasts suggested a much more restrictive policy stance than had been expected. Its forecast for the funds rate at year-end was raised from 3.4 percent to 4.4 percent and a further hike next year was projected, deflating market hopes for rate cuts in 2023.
It is far from a sure thing that the Fed will deliver on those forecasts, however. The more hawkish rhetoric was due in part to the fact that markets were not behaving in a manner consistent with a monetary tightening regime designed to bring inflation down. After its first 75bp rate hike in mid-June—bringing the funds rate up 150bps in a mere 3 months—stock prices rose more than 15 percent and bond yields fell nearly 100bps over the following two months. If increases in financial asset prices had persisted it would have meant even more rate hikes than would have otherwise been necessary. Lower stock prices and higher bond yields—along with a stronger dollar—are part of the process through which Fed tightening slows the economy. Now that the Fed’s message has come across effectively, future policy action will depend on how the economic data play out.
The Fed will look at a wide range of inflation measures as well as what drives them when determining its policy stance. It will also pay close attention to the labor market since employment costs are a major input into the prices of services, where both activity and price pressures are now strongest. The job market remains extraordinarily tight, reflected in unusually elevated job openings, high quit rates, strong job growth, and a historically low unemployment rate. Labor shortages are now easing reflecting the ongoing slowdown in the economy: Job openings are falling sharply and there are widespread reports of hiring freezes and layoffs. But there is still a long way to go to balance the labor market.
More rate hikes are surely coming at the last two Fed meetings of this year, which should bring the Fed’s policy rate to just over 4 percent. But there is a very good chance that the Fed will go on hold for an extended period around the turn of the year. By then there should be further evidence that inflation is heading down and that labor market shortages are shrinking. Most importantly, Fed officials are well aware that monetary policy affects the economy and especially inflation with a lag, so they will likely wait to see how the economy and inflation play out following what will then have amounted to more than 400 bps of rate hikes in less than a year.
U.S. Economy Is Likely to Be Weak for Many Months, but Not Crash
The extent of damage to the economy in this cycle will probably not be anything nearly as bad as what was experienced during the financial crisis. Recessions can be characterized as corrections for excessive behavior and this time around the excess was mainly in the public sector, which is now being corrected by significant policy tightening. Private sector balance sheets for both households and businesses remain healthy and show little sign of excessive leverage, while the U.S. banking system is well capitalized and not over-extended.
But the resilience of the U.S. economy has a cost, and it is that we will probably need an extended period of very sluggish growth – or even outright declines or no growth at all for several quarters – to put the labor market back in balance and get inflation down to low single digits on a sustainable basis. A 4 percent-plus funds rate is restrictive, but not terribly so. As a result, the Fed will probably need to maintain it for quite some time.
Further Damage to Financial Markets Is Likely to Be Limited
The 10-year Treasury yield will probably end up with a 4-handle, as inflation is likely to settle a bit above the Fed’s target of 2 percent next year – say around 3 percent. The Fed is unlikely to pursue a policy of extreme restrictiveness that would put the U.S. economy into a much bigger contraction just to get core inflation down to 2 percent. With a severe recession unlikely, the decline in stock prices thus far does not seem wholly inconsistent with economic fundamentals. There is probably somewhat more further downside risk than upside as the bottom in the economy has not yet been reached. In addition, inflation has shifted from demand-pull—which boosted profits—to cost-push, which should put pressure on margins. That said, the superior performance of the U.S. economy suggests its stock market remains attractive relative to that of other countries, which should help to limit the downside.
