Saying inflation is of central concern to investors at this point is the same as saying President Trump was a controversial leader. They are equally freezing-cold takes and aren’t exactly groundbreaking news to anyone paying attention.
Why is a Recession More Likely Now?
A faster-than-expected recovery from the coronavirus pandemic made possible through massive stimulus packages, loose monetary policy, and the rapid development of a vaccine has now led to a different problem. Prices have been soaring and manufacturers and supply chains have been unable to keep up with the change in demand. Shortages in vehicles, commodities, technology hardware, and most recently, fuel have led to prices rising 8.3% year-over-year as of the latest Consumer Price Index (CPI) report.
As inflation remains high with May’s CPI report expected to show another 0.7% monthly jump (8.4% annualized rate), investors are growing increasingly worried about an extended period of stagflation if not a flat out recession. The economy is already slowing down and the World Bank has just recently said it expects most countries are nearing a recession following the rapid recovery from the lows of the pandemic.
The cherry on top of this is that the Federal Reserve and central banks around the world are tightening monetary policy and raising rates instead of trying to keep policies loose in order to avoid a recession. High inflation, slowing growth, and tighter policies sounds like a pretty terrible combo but the actual data may point to the Fed being able to raise rates while navigating through a potential recession and/or period of stagflation.
Where is the Economy Now?
A period of stagflation usually calls for three primary conditions: high inflation, slowing growth, and high unemployment. One is undoubtedly occurring right now, another is showing signs of happening, and one is absolutely not a problem at the moment.
Inflation has been high recently and Snoop Dogg likes to get high, these are fundamental truths.
The economy is certainly slowing down after real gross domestic product (GDP) fell in the first quarter of 2022 and many of the largest companies in the world reported disappointing earnings results for the first quarter and issued warnings about second quarter performance. Retailers have been the latest culprit with Target (TGT) issuing its second guidance cut in the last few weeks while other retailers such as Walmart (WMT) didn’t meet expectations. It hasn’t just been retailers though with the likes of Apple (AAPL) and Amazon (AMZN) experiencing supply chain issues and even Elon Musk recently saying that he wants Tesla (TSLA) to cut 10% of its staff.
The economy had to slow down after the rapid recovery from the pandemic that has real GDP back above where it was before the coronavirus struck. Additionally, quarantine measures in China further hurt performance but Beijing has begun easing restrictions in a hopeful sign that the country will be back to “normal” soon. Lastly, the economic impact of Russia’s invasion of Ukraine isn’t likely to be so temporary as there have been no signs the war will be over anytime soon.
Despite all that, unemployment is far from a concern and in fact the larger issue is a labor shortage that has been pretty evident when going into most retail businesses. Unemployment currently sits at 3.6%, far below long-term averages and roughly where it was right before the pandemic which is pretty great considering the 70-year low rate is 3.4% and typical targeted rate is 4%.
One thing analysts have pointed out is that the labor force participation rate is down, meaning that the real rate might actually be higher. That is still the case but the participation rate has been steadily increasing and now sits at 62.3% compared to 63.4% before the pandemic and low of 60.2% in April 2020. The labor market might be more complicated than just looking at a low unemployment rate, but it's pretty clear that high unemployment is not a factor at the moment when it comes to potential stagflation.
What is the Fed’s Plan and Can it Succeed?
The Federal Reserve recently began raising interest rates and at a faster-than-expected pace with a 50 basis point hike recently and more of the same expected in the coming months. The central bank is targeting a short-term interest rate around 3% in 2023 to go along with its run-off of some of the assets on its balance sheet in order to fight against inflation. The higher borrowing costs may not help economic growth, but the bank believes the economy can withstand the higher rates without going into a recession.
The Federal Reserve isn’t alone in this move either as the European Central Bank recently initiated a new policy path that is set to end trillions of euros of asset purchases and raise rates to end its eight year run of negative interest rates. Inflation was already a growing concern globally but it's no coincidence that both Europe and the U.S. accelerated rate hikes following sanctions against Russian oil that will and already has led to higher energy prices.
The most important question again though is: Can central banks raise rates and avoid a recession?
Well, yes they certainly can but it's not going to be easy. Inflation is high and growth is slowing but the labor market is adding jobs and people are still spending money on goods and services despite price increases.
Goldman Sachs economists recently noted that the Fed can raise rates and avoid a period of recession at the cost of over a year of below-potential growth. Goldman further noted that the Fed must make sure wage growth doesn’t surge and that economic growth slows by roughly 1% so that the labor market can rebalance from a drop in demand for labor.
Wrapping Up
External factors in Russia and China have made the juggling act even more difficult but a recession can still be avoided. However, even Fed Chair Jerome Powell has admitted there will be some pain experienced in fighting inflation and lowering demand.
The real question is how much pain there will be. A short but severe recession or an extended period of slow growth with still relatively high inflation? Neither are great but avoiding a recession and making sure people still have their jobs should almost certainly be the desired outcome. It’s just gonna be a difficult task but one where hopefully the economy can sustain itself without the help of low rates and heavy stimulus measures.
