June 17, 2022 — Even before the Federal Open Market Committee of the Federal Reserve (Fed) hiked its target interest rate by 0.75% this week, there was plenty of debate on whether the U.S. economy is heading toward a recession or able to avoid one. With inflation once again surprising to the upside in May and the Fed responding with an ever more aggressive rate hike path, the debate has intensified and the response in equity markets suggests investors have tilted more toward a recession outcome. We agree that risks have risen, especially since the release of the May inflation report last Friday. However, we still expect the economy to avoid recession. Part of that expectation rests on a baseline forecast that inflation will moderate going forward. There is, though, the risk that inflation will remain persistently high, in which case the Fed would likely get more aggressive and raise the risk of a downturn.

Economy

Cue the slowdown

The economy downshifted from its torrid pace last year as expected but is at risk of slipping into recession in the next 12 months if the Fed is forced to keep cranking rates higher. In fact, the economy as measure by gross domestic product (GDP) contracted at a 1.5% annualized rate in the first three months of the year, though the details are important. Domestic consumer and business spending remained strong in 1Q 2022, but the overall figure was dragged negative by a slowdown of inventory accumulation, and even more so by the international trade component. That same strength from domestic consumers and businesses drove imports higher, and those are a subtraction from GDP. U.S. exporters were hurt by a weak global economy, dragging overall production into negative territory.

Figure 1: U.S. real GDP growth (%)

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Data as of May 31, 2022. Sources: Bureau of Economic Analysis, Wilmington Trust.

 

Not expecting recession

We are expecting stronger numbers for the remainder of the year and for growth in 2022 to finish around 2%. That is a downgrade from our previous expectation of 2.4%, based on a higher path for oil prices and faster rate hikes by the Fed. The hawkish turn by the Fed that started in December 2021 has already pushed mortgage rates up the fastest over a six-month time frame since 1981 and we expect homebuilding to be a drag on overall growth this year. Fundamentally, consumers and businesses remain healthy. Job growth is strong and so is consumer spending. Capital expenditure plans by firms have softened so far in 2022, but are coming down from dizzying heights last year and remain in positive territory.

Risks to the outlook

The risks to the outlook come from energy, food, and the Fed. Russia’s war on Ukraine is exacerbating a global oil market that was already set to be undersupplied before the first shots were fired. OPEC has very little spare capacity and we have yet to see swing producers in the U.S. jump into the fray. If energy prices keep climbing, it will continue to take a toll on U.S. consumers and businesses. The same is true for food prices by way of Ukraine’s role as “breadbasket to Europe” and the shortage of fertilizers due to the war.

There is a growing risk of an extended, global food catastrophe that would weaken international economies, create civil unrest in volatile regions, and pull spending away from other items in wealthy countries. Last, if inflation does not moderate (as I describe later on) and remains persistently high, the Fed is committed to an aggressive policy response and is, in our view, willing to cause a recession to stop high inflation from becoming well-entrenched as it did  in the 1970s.

Labor

Job growth still strong

Tightness in the labor market is the proverbial double-edged sword that drove wages higher— which lurched more people back to the market but also threatens to keep inflation persistently higher. Crucially for the economic outlook, job growth has been robust, and we expect that to continue. Other than the COVID-19 recession of 2020, the U.S. has not entered recession in the past four decades when job growth was averaging private job gains above 100,000 on a six-month basis. Over the past six months, the U.S. has added 505,000 jobs per month on average and employers remain eager to hire. There is obviously a risk is that firms change their tune rapidly in a deteriorating and high-interest rate environment over the next 12 months, bringing on a recession.

Figure 2: U.S. job growth (m/m)

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Data as of May 31, 2022. Sources: Bureau of Economic Analysis, Wilmington Trust.

 

Unemployment rates and recessions

At his June 15 press conference, Chair Powell described the Fed’s projected unemployment rate of 4.1% at the end of 2024 as a “successful outcome.” That would be a half-point increase from today’s 3.6%, and he was somewhat evasive in responding to whether reaching such a goal requires job losses. In a purely mathematical sense, it is very possible to have a rising unemployment rate without job loss, if the labor force grows faster than hiring. For example, if 200,000 people on average joined the labor force each month but only 165,000 of them successfully found work, the Fed’s forecast would be achieved. More practically, the appetite for labor is currently so strong it’s hard to imagine 35,000 people failing to find work each month. Perhaps more to the point: Historically, there are precious few examples of an increase in the unemployment rate of 0.5% without entering a full-blown recession. We are not in normal times to be sure, but the Fed’s path would be nearly unprecedented.

Wage relief

We find recent wage dynamics to be encouraging. In July 2021, employers were scrambling to find workers and had posted 2.9 million new openings over a five-month period. Only one million people joined the workforce over that same time-frame. Accordingly, wages surged, reaching 6.4% on a three-month annualized basis. There was some speculation around that time that workers would return over the summer in which half the states ended the extraordinary unemployment benefits program, and even more in September when those benefits ended nationwide. That unfortunately did not transpire. It appears that COVID was the stronger deterrent. After the Delta and Omicron waves came and went, the labor force has surged in 2022 by 2.1 million while labor demand has slowed markedly. Job postings are up just 478,000 over that time period. With labor supply growth now exceeding new postings, annualized wage growth has fallen to 4.7%. We expect strong labor force gains to continue and wages to decelerate further, helping to ease inflation.

Figure 3: Growth in labor force and job openings (Five-month change, millions)

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Data as of May 31, 2022. Sources: Bureau of Economic Analysis, Wilmington Trust.

 

Inflation

The key to it all is the path forward for inflation. The Fed started getting hawkish in late 2021 at the first sign of broad-based inflation and it is committed to aggressive rate hikes until it sees “convincing [and] compelling evidence that inflation is coming down” in the form of a “series of declining monthly readings.” We believed that had started in earnest in February and March before getting stung by consecutive monthly readings of 0.6% m/m in April and May (Figure 2).

On one hand

Digging into the details, we’re encouraged by the slowdown in most categories (gray). Even the upside surprise reading for May (that sent markets into the current selloff) showed encouraging price declines for consumer goods, such as the ones that national retailers like Walmart and Target have indicated overstocking. Prices fell for smartphones, televisions, sporting goods, appliances, furniture, bedding, and window treatments, to name a few. We expect this dynamic to continue as demand for goods continues to wane.

On the other hand

The surprises came from cars, airfare, hotels, and housing. Autos, particularly used ones, have been a main culprit in the rampant inflation and consumers finally started to get relief on prices in February and March only to see another acceleration in the past two months. High frequency trackers are pointing to relief again so far in June, and major automakers have signaled optimism on production of new autos this year, yet risks remain. Airfares, which track very closely with jet fuel prices also jumped in April and May. Here again high frequency data are  showing an encouraging, regular seasonal decline in prices in June, but jet fuel prices could drive airfares higher again.

Housing, or “shelter” as it is known in the inflation data, is likely to be the most persistent challenge for inflation even though housing activity is hitting a wall. In last week’s inflation report, the month-over-month gain in the overall shelter line item moved up 0.6%, the biggest jump since 2004, and the owner component had the biggest gain since 1990.

We do expect home prices to slow very soon. The average 30-year mortgage rate has jumped 2.7% since the Fed first turned hawkish six months ago, the largest six-month jump since 1981. That has put the brakes on activity, sharply pushing down homebuilder confidence, foot traffic of potential buyers, building permits, housing starts, and mortgage applications. Home price data lags by several months but should reflect a slowdown in price gains very soon. However, there are quirks in the methodology of collecting data for the inflation index that mean we may not see weaker prices flow through to the data for as long as 14 months.

Figure 4: Core consumer price index inflation contributions from components (% m/m)

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Data as of May 31, 2022. Sources: Bureau of Labor Statistics, Wilmington Trust.

 

Food and energy matter

The aforementioned inflation discussion is silent on food and energy. Economists focus on “core” inflation not to ignore these critical components, but simply because they are so volatile that core inflation is a statistically superior way to measure the underlying trend in price pressures.

Russia’s war on Ukraine has already driven energy prices higher in a year when petroleum was slated to be undersupplied anyway. Worse, a shortage of grain and fertilizers resulting from the war are likely to cause food crises in spots around the globe and drive prices higher for all countries. We view this as more of a threat to economic growth than to inflation. With consumers cutting back on spending, ever-higher food and energy prices are likely to pull spending away from other items and pull those prices down.

We have been calling for a deceleration in inflation for several months (Figure 5) and still expect that to be the case. Last week’s upside surprise from the CPI clearly delays that slowdown but we still see the fundamentals as warranting a slowdown, which we think would be between 5.5% and 6.0% by the end of this year, with further deceleration next year.

Figure 5: Consumer price index inflation and forecast (% y/y)

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Data as of May 31, 2022. Sources: Bureau of Labor Statistics, Wilmington Trust.

 

Federal Reserve

A big hike this week and more expected

The Fed’s first hike of 0.75% in nearly 30 years reflects the urgency the central bank senses to get inflation under control. It sees an economy that is operating above full capacity, like a car that is flying down the road a little too fast, yet it still has its foot on the accelerator. This week’s hike brings the Fed’s main tool, the federal funds rate, to 1.75%. It deems neutral to be  somewhere in the 2.0%—2.5% range, so in the committee’s minds, all they’ve done so far is to let up on the gas pedal to some degree. The Fed’s projections for future rate hikes show the rate at 3.5% at the end of 2022 (pressing on the brake pedal a bit) and 4.0% by the end of 2023 (pressing a bit harder).

The rates that matter most have moved more

It’s important to point out that the Fed has already pressed on the brake, in our view, tightening conditions more than the federal funds rate suggests. That rate is not directly used by very many people or businesses. It’s an overnight rate at which banks lend to one another. The real impacts come as the Fed’s policy and its communications about future policy affect the interest rates that matter. The 1- and 2-yr Treasury yields are up 2.6% and 2.4%, respectively, since the Fed turned hawkish in December 2021. The 10-year yield is up 1.75% and the national average 30-year mortgage is up 2.7%. We believe those movements are having a material impact on the economy already, most clearly seen in the housing market as earlier described.

The path forward

We expect the Fed to hike more this year, but our baseline inflation view would suggest less tightening than the median Fed official and less than market pricing. Chair Powell indicated this week’s 0.75% hike was “unusually large” and does not expect such hikes “to be common,” also stating the committee expects to hike by either 0.50% or 0.75% at the upcoming July meeting. We expect 1.25% more in hikes over the course of the year, bringing the top of the Fed’s target range to 3.0% by the end of the year, and only slightly more tightening in 2023 to a peak of 3.25%. That said, the future for inflation is highly uncertain. We have been surprised by the most recent inflation readings and the Fed could surprise again to the upside going forward. To the extent that inflation remains persistently high, the Fed would need to be more aggressive than our baseline and would increasingly risk tipping the economy into recession.

Figure 6: Consumer price index inflation and forecast (% y/y)

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Data as of May 31, 2022. Sources: Federal Reserve, Wilmington Trust.

 

Core narrative

The combination of high inflation, risks from abroad, and an aggressive Fed bring material risk to the U.S. economic outlook. Our baseline is for the economy to avoid recession, an expectation that is supported by a strong labor market and solid household balance sheets. But consumers’ moods are sour in the face of inflation and could retrench. Businesses could do the same. We expect inflation to moderate going forward and for the Fed to tighten, but not overly so. If inflation keeps surprising to the upside, which is very possible, the Fed would need to get more aggressive.

The uncertainty argues for caution in portfolios. We hold a neutral position to U.S. and international developed equities, a slight overweight to emerging markets, and an underweight to core fixed income, and we are overweight cash. We continue to monitor the risks on either side of the outlook and will respond in portfolios accordingly.

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