I have been on many delayed flights recently and have a certain sympathy for the pilots who, having repeatedly told us that we would be taking off shortly, have to continually backpedal due to weather or staff or equipment. They always thank us for our patience but in reality they are the patient ones. We, the passengers, are seething, and what’s more, we have suddenly become vocal experts on dodging weather, managing staff and fixing planes. But to get us safely to our destination, the pilots have to keep their cool.
In a similar vein, following another super-hot CPI report last week, the public is losing patience on inflation and there are loud calls for the Federal Reserve to boost interest rates more aggressively. However, powerful forces outside the Fed’s control largely caused the current inflation spike and a reversal of those other forces will likely cure it. For the Fed, the most important task is to recognize the strength of those forces and maintain a balanced and flexible approach to allow inflation to fade without triggering a recession.
In particular, the economy is now experiencing major drags on demand from much tighter fiscal policy, record high food and energy prices, negative wealth effects and slumping consumer confidence. While a more hawkish Fed is contributing its own braking power via higher mortgage rates and, indirectly, through a high dollar, it is important for the Fed to fully appreciate the other forces that will slow both economic growth and inflation in the months ahead.
Starting with fiscal drag, on Friday, the Treasury Department released data on the federal deficit through May. Based on these numbers, and using estimates for the last four months of the fiscal year, we now expect a budget deficit for fiscal 2022 of roughly $825 billion, or 3.3% of GDP down from $2.772 trillion or 12.4% of GDP in fiscal 2021. The good news in these numbers is that the national debt is now shrinking as a share of GDP and the risk of a near-term fiscal crisis has fallen. The more sober news is that this represents the single biggest fiscal drag since the demobilization following World War II as the private sector gets squeezed by an end to stimulus checks, enhanced child tax credits, enhanced unemployment benefits, aid to renters, aid to small businesses and more. This is already slowing consumer spending and will drag some more, once consumers have worked through the savings and credit card space they accumulated during the pandemic.
A second issue is the impact of higher energy and food prices, which Friday’s CPI report showed rising by 35% and 10% respectively over the last year. Most families have little discretion in how much gasoline they consume in the short run and, while food spending allows for more flexibility, shunning what you want to eat in favor of what you can afford to eat is a miserable business. Higher prices in these areas will force cutbacks in others as well as contributing to the generally gloomy mood so evident in last Friday’s record low reading on the University of Michigan Consumer Sentiment Index.
The housing industry is also seeing some sudden headwinds. A combination of surging prices in recent years and surging mortgage rates in recent months has crowded many potential home-buyers out of the market and could snuff out the steady expansion in homebuilding that had seen housing starts rise to a more than 15-year high of 1.72 million units annualized in the first quarter of this year.
In addition to all of this, trade is being hurt by a rise in the U.S. dollar that has raised its value, in real terms, to its highest level since 2002 and almost its highest level since 1986. We expect this to help boost the real trade deficit from 6.6% of real GDP in 2021 to 7.7% in 2022, knocking another 1%+ off real GDP growth.
It is still possible, and maybe even probable, that pent-up demand for workers, goods and services, combined with still healthy consumer and corporate balance sheets and a lack of overbuilding in the cyclical sectors of the economy will prevent these forces from dragging the economy into recession. However, they will undoubtedly slow both economic growth and inflation in the year ahead.
That being said, a key question for investors this week will be whether the Federal Reserve appreciates both the position of the economy and the strength of the forces already operating to slow it down.
Answers should be provided in the FOMC statement, the Summary of Economic Projections and Jerome Powell’s press conference.
On the statement, there should be some changes in tone relative to the press release following the May 4 FOMC meeting. The Fed will likely first emphasize the undesirable persistence of inflation pressures seen in a red-hot May CPI report and continued very high energy prices. They may note that the decline in the unemployment rate has slowed but they will likely assert that labor markets remain very tight.
In the statement, they will very likely announce an increase in the federal funds rate of at least 0.50%. However, futures markets are now pricing in a virtually 50/50 shot of a 0.75% increase and, were they to do this, we would likely see both a further increase in short-term rates and a decline in long-term rates as investors bet more heavily on rate hikes in 2022 leading to recession in 2023.
The Fed’s Summary of Economic Projections should provide further insight into how they see the economy evolving. Relative to their mid-March forecasts, they may reduce their estimate of year-over-year real GDP economic growth in the fourth quarter of 2022 from 2.8% to 2.0%, largely reflecting the first-quarter slide seen in both real GDP and productivity. They may also increase their estimates for year-over-year headline and core consumption deflator inflation for the fourth quarter of 2022 from 4.3% to 5.5% and 4.1% to 4.2% respectively. Importantly, however, they are still likely to project declines in both growth and inflation in 2023 and 2024 and a relatively stable unemployment rate.
There will be more dots in the Fed dot plot this time around with the addition of Lisa Cook and Philip Jefferson to the Board of Governors. Even with this, however, a more hawkish message will likely be clear in the data, with the median forecast for the end-of-2022 federal funds rate likely to climb from 1.9% in March to at least 2.6% and possibly 2.9%. 2.6% would reflect 50 basis point hikes in June and July and 25 basis point hikes in the three remaining meetings of the year. 2.9% would presumably reflect an expectation that the September hike is likely to be 0.5% rather than 0.25%.
Finally, in his press conference, Chairman Powell will had the unenviable task of providing a balanced assessment of the economy, emphasizing that he still expects both inflation and economic growth to slow and advocating a steady approach to policy while, all the time, assuring the public that he appreciates how upset they are with inflation. But that is his job and it is very important that he provides this balanced perspective.
If he does so, both the short end of the bond market and the U.S. equity market could rally accompanied by a dollar decline. However, even if he doesn’t, and markets sell off further, investors would do well to focus on valuations. On Friday, 10-year Treasury yields rose to 3.17%, almost their highest level in a decade while the forward P/E ratio on the S&P500 fell to 16.3x, now below its 25-year average of 16.9x. Whatever short-term cyclical journey the economy takes from here, it should, within a few years, resume a brighter path of moderate growth, low inflation and high profitability. If it does so, investors may well be able to realize good returns on assets being sold today at a time of understandably negative sentiment.