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.