USA: Too Hot, Too Cold, or Just Right?

At the 16 March FOMC meeting, US Federal Reserve Chairman Jerome Powell emphasised the central bank’s determination to lower inflation towards the 2% target. To this end, the FOMC raised the Federal Funds rate by 25bp, and Chairman Powell indicated similar rate hikes should be expected at future meetings. Further, he warned the FOMC was prepared to adjust its monetary stance even more quickly if necessary to curb rising consumer prices. At the gathering, the FOMC also updated its economic forecast, which suggested inflation would approach its target in 2024 while GDP growth would remain above the long-term trend throughout the 2022-2024 period.

In the children’s fairy tale, Goldilocks would describe this forecast as “just right”, as she labelled her favoured bowl of porridge. The problem is, however, many doubt this “soft landing” outlook. Some believe the US economy is running “too hot”, and that inflation may become a persisent problem. Others, on the other hand, fear the US economy is heading towards recession, e.g. growth is “too cold”. To gauge the risks of inflation and GDP growth, we need to assess carefully the factors contributing to the ongoing surge in prices. Rather than any of the three outcomes in the fairy tale, I believe inflation may remain above target until 2025. And, in order to lower inflation towards 2%, GDP growth will need to slow below the long-term trend (1.8%) in 2022/23, and perhaps into 2024.

So, while recession may be averted (although I attach a 25% possibility for a 2023 slump), a period of stagflation is the most likely outcome (I introduced this possibility in my 2022 Strategy Outlook entitled “Avoiding Stagflation?”). In order to achieve this aim, the Federal Funds rate is likely to rise towards 2% this year before peaking near 2.5-2.75% by mid-2023. Despite its preference to raise interest rates in small increments, I anticipate the Federal Reserve will hike the key rate 50bp at either the May or June meetings, and at both quite possibly. As I have written previously, the S&P 500 PE ratio will decline, as interest rate rise. Therefore, I maintain my 2022 S&P 500 forecast of 4,300 (established in the November 2021 blog), but believe a correction towards 4,100 is quite feasible.

Too Hot: The Risk of Persistent Inflation?

To be sure, the spike in food and energy prices is adding to inflationary pressures. However, despite President Biden’s protestations, price growth was accelerating well before the Russian invasion. In broad terms, inflation has surged as global supply has not been able to satisfy pent-up worldwide demand as Covid restrictions were eased. Many forecasters, including the Fed, thought this imbalance would be short-lived. However, the Chart above suggests that supply chains are still contributing to rising prices (even excluding the impact of food and energy). Hopefully, this source of inflation will abate eventually.

Inadequate labour supply poses an even more serious risk to the inflation outlook. Indeed, the US labour market is now tighter (and worker shortages more prevalent ) than prior to the two most recent recessions (Chart above). Most worrisome, as a result, wage growth has been accelerating: average hourly earning rose 5.6% in the March (next Chart).

Price growth becomes entrenched if rising wages lead to higher inflationary expectations. The following Chart suggest this may now be happening, which risks producing a classic wage-price spiral.

Some monetarist pundits (including cyrptocurrency enthusiasts) suggest rapid money supply growth is the main source of inflation. In a previous blog (“Global Money: Will the Boom Go Bust?”), I suggested the secular decline in the velocity of money (reflecting low inflation and interest rates) has weakened the link between M2 and price growth (next Chart). Indeed, velocity continues to decline (demand for money increase), despite the recently accelerating inflation. Of all the things to worry about, money growth is not one of them. Furthermore, M2 growth is now slowing sharply.

Too Cold: Heading for Recession?

To be sure, the dramatic expansion of fiscal policy during the pandemic has contributed to the recent acceleration in price growth. Indeed, in an earlier blog (“Global Fiscal Policy: Keep the Pedal to the Metal”), I suggested the much-needed US budgetary stimulus was larger than required. However, as Covid-related spending is now abating, fiscal policy has now become a large drag on economic activity (next Chart).

Likewise, rising food and energy prices are taking their toll on household incomes in real terms. Already slowing income and consumer spending growth would greatly support the “too cold” recession outlook (next Chart).

Recessions are almost always a result of a policy mistake: typically, when confronted with inflation, central banks tighten monetary policy too much. With US fiscal policy already restrictive, some fear the Fed may raise interest rates too much (or too quickly). Indeed, the recent flattening of the US Treasury yield curve has contributed to recessionary concerns. To be sure, the shape of the yield curve is a good leading indicator of economic slumps. In previous cycles, however, inverted yield curves resulted from tight monetary conditions, e.g. high and rising real Fed Funds rates. As the following Chart illustrates, that’s not the case now. Real rates are very low, and monetary conditions remain extremely accommodative.

With inflation rising, fiscal policy tight, and the Fed well “behind the curve”, the risk of a policy mistake is substantial. The likelihood of an error is increased by the very unclear economic outlook. Indeed, JP Morgan’s Chart (below) indicates the scale of economic forecast revisions (GDP and inflation) is particularly large at present. Even the Fed’s crystal ball is very cloudy. During the past year, for example, the central bank has increased its 2022 inflation projection from 2% to 4.1%, while slicing its GDP forecast from 4% to 2.8%.

“Just Right”: Soft-Landing or Stagflation?

Controlling inflation and engineering a “soft landing” will require that supply and demand become more balanced. Restrictive fiscal policy and the impact of higher food and energy prices will slow consumer spending meaningfully in the period ahead.

Can expanding aggregate supply contribute to lowering inflation? Enhancing the workforce would assist in slowing wage and prices increases. The Chart above, however, illustrates the labour participation rate amongst prime-aged and young people has nearly recovered to pre-pandemic levels. On the other hand, many older workers have opted for early retirement. Perhaps higher inflation and financial market volatility will encourage this demographic to return to work. There’s some evidence this is happening, which would take some pressure off the Federal Reserve.

Likewise, stronger productivity growth would also offset the inflationary impact of rising wages. Indeed, a major cause of 1970’s stagflation in the wake of the OPEC oil embargo was the slump in labour efficiency. The Chart above suggests the productivity trend is improving from the tepid pace following the Global Financial Crisis. However, with wages growing over 5%, annual productivity gains of 2% will not lower underlying inflation below 3%.

Therefore, with the supply-side options limited, lowering inflation to the Fed’s 2% target over the medium term will require below-trend US GDP growth for a couple of years. The combination of sub-par economic growth and above-target inflation — that is, stagflation — appears the likely outlook for for 2022 and 2023.

Strategic Considerations

  • A period of stagflation — combining below-trend GDP growth and above-target inflation — is the most likely economic outcome in 2022-2024. I project GDP growth of 1.7% and 1.3% (on a Q4/Q4 basis) in 2022 and 2023 respectively. Core PCE inflation will peak in Q2 2022. Nevertheless, underlying price growth is projected at 4.5% and 2.8% in 2022 and 2023 (Q4/Q4 basis).
  • The Federal funds rate will reach 2% by year-end 2022, and hit 2.5-2.75% by mid 2023.
  • As interest rates rise, equity P/E valuations will decline towards 17X earnings. While I maintain my 4,300 S&P 500 target, a slide towards 4,100 is possible before new highs are achieved in the future. Sell the current recovery rally!
  • The US dollar should strenghten further this year, but will depreciate in 2023 as the ECB begins hiking interest rates.
  • The risk of policy mistakes is high, as a classic wage-price uptick is emerging. The possibility of a 2023 recession is at least 25% at this stage.