Can the Fed Land the Plane?
Published on March 11th, 2022
We expect a tug of war between the economic expansion and the Federal Reserve’s efforts to fight inflation will keep financial market volatility elevated this year. Fortunately, the U.S. entered 2022 with good economic momentum. On the other hand, inflation is high. The root causes include fiscal and monetary stimulus in response to the 2020 recession, whose stimulative effects have persisted after a rapid recovery. Inflation was likely exacerbated by the pandemic impacts which shifted consumption to goods, created bottlenecks in manufacturing components and transporting them over logistics networks, and held back labor supply due to health and childcare concerns and early retirements. In addition, we expect the recent bout of home price appreciation to feed into apartment rents over time. Now the Ukraine conflict has added further inflationary pressure by raising the price of oil and gas, as well as other commodities including wheat, metals, and fertilizers.
With all of this as a backdrop, we believe the Federal Reserve has little choice but to tighten policy to fight inflation. If the Federal Reserve can gradually move inflation back to target while not derailing the economic expansion, then we believe the market can rebound and potentially advance for years. But if the Federal Reserve tightens too rapidly, and the economy tips into recession, the market may decline further. So, can the Federal Reserve land the plane – in the sense that it must tighten only enough for an economic soft landing, but no further?
We believe inflation may continue to accelerate over the next few months before finally reaching a peak. We then expect it to decline, but perhaps more slowly than the Federal Reserve has forecast. In our view, the decline in inflation should occur as consumption shifts back to services, demand moderates as excess savings are spent, the private sector addresses the twin bottlenecks in manufacturing and logistics, and workers return to the labor force. The comparisons versus a year ago also get easier as the year progresses.
We believe the risk of recession has increased. Evidence for this can be found in the flattening yield curve and dramatically higher oil (and gasoline) prices, items we have touched on in recent blog posts. More recently, the poor performance of cyclical stocks (outside of the energy sector) indicates that many investors increasingly have come to believe that earnings estimates for these companies will be dramatically reduced, which is typically seen when economic growth slows materially. All three of these flags typically precede recession. One measure holding up well is credit spreads. These have widened, but not to distressed levels, in part due to the importance of the energy sector in the high yield market. We expect financial market volatility is likely to persist, as investors continue to revise probabilities around this bimodal distribution (recession or no recession), with very different implications for asset prices depending on where they land.
Historically the U.S. economy has slowed when materially higher gasoline prices weighed on consumer spending. In the years of elevated crude oil prices following the Arab Spring, the U.S. shale oil production boom was sufficient to offset this economic impact. Currently we believe that higher gasoline prices will again be a net negative for the U.S. economy, as the demand response from shale oil producers appears insufficient at this time to offset the headwind to consumption as consumers seem likely to make fewer discretionary purchases. We expect the Federal Reserve to raise interest rates at nearly every Federal Reserve Open Markets Committee meeting this year. This might weigh on asset prices including homes, bonds, and stocks. It might also slow the economy.
We expect Russia to continue its war until Kyiv falls. At that point the conflict may switch to an insurgency. Therefore, the geopolitical price premium embedded in crude oil and other relevant commodities appears unlikely to fully subside without more of an offsetting supply response. We believe the level of the price premium is correlated to investor fears that Russia may escalate the conflict with an attack on a NATO nation. Alternatively, it is possible that the conflict ends with a negotiated settlement sooner than expected. In that scenario, the West would likely reward Russia with a reduction in sanctions. But we believe large multinationals, which have been rapidly shutting down their operations in Russia and in some cases writing down the value of those assets, would likely be slow to reconnect, because Russia is a small actor in the context of the global economy, and the risk remains that future Russian actions could lead to a reimposition of sanctions. Overall, this would appear to suggest that the inflationary impact of the Ukraine conflict could be with us for some time.
While it is difficult to know, we believe the odds of a recession in the next 12-18 months may have increased from under 20% at the start of the year, to between 30-50% currently. This change in our view is largely the result of the dramatic upward change in the price of oil and gasoline since the end of February, and the increased odds of a protracted war in Ukraine. However, the situation is volatile, and we may yet revise our view further in the coming weeks and months.
We must also keep in mind that there are strong counterarguments to the recession scenario, including a robust US economy with companies continuing to add to payrolls at a rapid pace, and wages that continue to rise. Manufacturing and services activity measures remain healthy. It seems likely that there will be a reopening tailwind following the recent collapse in COVID cases. We also see the data which indicates corporate inventories are low, and rebuilding of inventories has historically been a strong driver of economic activity. Despite an uptick in mortgage rates, housing activity remains strong, and consumers are sitting on $2 trillion of excess savings, which could serve as a strong buffer to many headwinds. As always, we will be carefully monitoring developments, and adjusting our views as necessary.