Inflation Shows Signs of Slowing, but Investors Need to Prepare for a Recession

Central Banks are facing a historical challenge. Questionable monetary policy choices for the past 40 years have to an economy that has fostered unsustainable debt. Taking on debt was in fact encouraged as a way to promote economic growth. As time went on, debt became increasingly unproductive. In more and more cases, the investment of borrowed money could not support the borrower’s ability to pay interest or repay the principal on debt. Whenever a crisis arose, central bankers have consistently responded with aggressive monetary policy by lowering interest rates and buying treasuries (QT).

In a regular, market-based, capitalistic society, insolvent debtors should go bankrupt. When bankruptcy faced “systemic institutions” - the large Wall Street investment banks - bailouts were handed out, with the implicit consent of central bankers.

That was made possible by one thing - low inflation. As long as inflation remained subdued, money could be created without consequence. This entire construct might have started to change in 2021 and leads us up to the point where we are now.

As inflation continues to sweep the globe, American investors and consumers alike are yearning for signs of some relief from the difficult market conditions at play. Feeling the pressure from record-high prices on everything from gasoline to groceries, Americans are looking for answers wherever they can find them. Unfortunately, nothing related to fiscal policy, global inflation, and recession fears is simple; there are many factors at play, and while some show signs of slowing inflation, others signal a looming recession. By examining all of these different factors holistically, we can better equip investors with the knowledge needed to weather the storm ahead, whatever it may be.

The Personal Consumption Expenditures price index is the measurement that the Federal Reserve uses to measure inflation and, although it’s just one measurement, the May report highlighted a 6.3% price increase year-over-year which is slightly lower than the 40-year peak in March at 6.6% growth, but unchanged from the April report. This index is what the Federal Reserve uses to gauge the severity of inflation and use its tools, such as hiking interest rates, to curb inflation. Although the Federal Reserve can use employment rates as another economic metric, these rates are lagging indicators, often not showcasing reality with enough time to be used in any preventative way. If we strip out food and energy prices from PCE (core PCE), we start to notice the start of a potential divergence.

A Shift in Messaging from the Federal Reserve

When inflation fears began happening in masse at the beginning of the year, Federal Reserve Chairman Jerome Powell was confidently messaging a “soft landing” in which the Fed would raise interest rates ever so slightly, curb inflation, and take things back on track. However, while speaking at a European Central Bank Forum in the last week of June, Powell mentioned that while a soft landing is still the goal, the “pathways have gotten narrower” to achieve it. 

The Fed cannot control many of the major factors contributing to record inflation such as the war in Ukraine, supply chain challenges, or the price of commodities; the biggest tool it has at its disposal is hiking interest rates. In June, the Fed raised interest rates by .75 percentage points, which was the largest increase since 1994. With many government leaders fearing that these hikes could lead to a recession and increase unemployment, Jerome Powell is in an unenviable position.

Now, interest rates are sitting around 1.5% and are expected to jump up to about 3.4% by the year’s end, which is much higher than the predicted 1.9% target published by the Federal Reserve in March. So, while interest rate hikes may slow down the economy enough to curb inflation, the question remains open about whether it will curb economic activity too quickly, leaving unemployment numbers and a recession hanging in the balance. Speculators are already betting that financial markets will exert enough pressure on Powell to change policy again, this time in a dovish manner.

Recession: Fear or Reality?

It seems that the word “recession” has been tossed around for months now, while investors are simply waiting for the shoe to drop. The only body not to acknowledge the word “recession” is the FOMC itself, as there is no mention of it in the latest minutes.

On this front, good news is not in abundance. After the first quarter of 2022 featured a GDP decrease of 1.6%, everyone is watching to see if Q2 numbers show a consecutive decrease, which, by definition, would mean a recession is already happening.

In the last week of June, the Atlanta Fed published an estimated GDP decline of 2.1% in the second quarter, signaling that a recession is upon us in full force. This model output, coupled with Jerome Powell’s recent remarks, leads us to believe that all signs point to “yes,” changing the question from whether or not a recession will happen to wondering just how bad the recession will get. To be sure, stock prices have already discounted slower economic growth to a certain extent. Lately, bad news has been cheered by the market, with the belief that the Fed will have no choice but to pivot in the face of a nasty downturn.

Feeling Relief from High Prices

The inflation that’s happening right now is reminiscent of inflation in the early 1980s which required steep interest rate hikes and a recession to bring back into alignment. However, these changes don’t happen overnight. Interest rate hikes take time to have an effect; supply and demand have to find alignment, which could take a number of years.

Everything that led us to this point was truly the perfect storm, that no central planner has control of: a global pandemic, a war in Europe that’s lasting longer than anyone thought, and supply chain disruptions that are sweeping the globe. All of these will all take time to get resolved. One hopeful indicator is the decline in shipping rates, which are costs that are often passed down to consumers. In March, it cost nearly $10,000 to ship a 40-ft freight container, but in May, that price dropped to $8,995. WTI oil briefly dipped below $100 on July 06, dropping from a recent intraday high of $130. Manny other commodities are showing the same discount pattern.

Because the market is seeing many of the same behavior trends as the inflation crisis in the 1980s, we can look at historical trends for clues on what we might be facing. Inflation peaked at 14.8% in 1980, but by 1983, it was at a 15-year low of 4%. Although the current situation is not an exact replica of what the US faced half a century ago, it signals to investors that erratic consumer behavior and unpredictable markets could impact portfolios for many months to come. Mark your calendars for July 13, when updated inflation numbers are released and July 28, when we get the first estimate of Q2 GDP Growth.

Signals from the Bond Market

The bond market also helps signal to investors what lies ahead. Looking at the 5-Year, 5-Year Forward Inflation Expectation Rate is one way to see what the bond market expects inflation to look like in the future. Right now, investors expect the inflation rate to be 2.10% five years from now, which is much more aligned with the Fed’s goal of 2%.  Longer term, bond investors view the current bout of inflation as “transitory” albeit to a longer extent that the word was originally used for.

CONCLUSION

Sit Down, Buckle Up, and Get Ready

Although it seems like inflation may be starting to slow down, it’s clear that the ramifications of curbing inflation come with their own nasty side effects. Similar to a life-saving medication that has a long list of potential challenges, lowering inflation rates will take time, cost money, and probably send the US into a recession. Things are going to get worse before they get better, but they will get better.

In the meantime, stay calm and make smart investment decisions. Limit volatility in your portfolio by moving slowly and keeping plenty of cash as a buffer. Be sure to avoid panic selling and making portfolio decisions based on your emotions; look at the respective markets, analyze the data, and make every move with confidence.

Jerica Kingsbury and Andrei Sota