Economic Update – Third Quarter 2022
Senior Vice President
Director of Treasury & Risk Management
The Federal Reserve waited too long before beginning its fight against inflation. We are all paying higher prices for food, clothing, gas, oil, cars, services like travel and eating out at restaurants, and goods of all kinds. Until early this year, the Fed’s focus seemed to be the unemployment rate and recovery from the pandemic. Now inflation is here and we hate it!
We spent too long waiting for the Fed to figure out that inflation was not “transitory” (to use Chairman Powell’s infamous phrase) and that inflation was, in fact, building momentum. The transitory narrative worked for about a month last year, before inflation started taking off with a vengeance. Supply chain issues and missteps caused much of the inflation by keeping goods in short supply, which resulted in higher prices. We had an oil crisis, a gas crisis, and an electricity crisis all at once. The Consumer Price Index headline peaked (for now) at +9.1% year-over-year in June, 2022 before falling back to +8.5% in July. Producer Prices were +9.8% in July over the prior year and was +11.3% in June. CPI and PPI, excluding food and energy, are currently just below +6% year-over-year. Relief from declining oil and gas prices gave us some breathing room, but the Fed still has lots of work to do with inflation trending at 4 to 5 times its target of 2%.
The Fed let inflation ride from last summer until March, 2022, when they took a baby step of tightening by .25%. In hindsight, it appears that this move was already too late to make a meaningful impact on 2022 inflation pressure. Even more egregiously, the Fed continued to purchase $100 billion of Treasury and Agency bonds in the market each month through March, 2022! This money was added even when it was known inflation was accelerating, and along with the fiscal stimulus handouts of cash, added fuel to the inflation fire. As pandemic spending began to recover, the Fed slowed money supply growth in 2021 from 25.8% to 12%-13% for the second half of 2021, and to single digits by June of 2022. The Fed has also announced they will allow their bond portfolio to begin running off at a pace of $47.5 billion per month until September, then at $95 billion per month after September.
Hindsight is 20/20 and they realize that they need to get interest rates higher- thus the .50% and .75% hikes in short-term rates in May, June, and July and get money supply down quickly. Cumulatively, the Fed Funds rate has been raised by 2.25% to 2.50%. They’ll meet again in September and will be deciding how much to raise rates. I would expect them to raise rates to at least 3.50% at year-end 2022.
GDP and Recession
The effects of Fed actions are realized with a lag of six to nine months, so I’m guessing there will not be much question about recession by then. We experienced two negative quarters of GDP, which is the textbook definition of recession, in the first and second quarters of 2022, by -1.6% and -.9%. Inventory changes were the predominant factor in the negative growth. If companies grow inventories too much, they may have to reduce prices to liquidate them. Walmart, Target, and Amazon can tell you this is true. But NBER is the organization that gets to call the recession; it will peg the beginning and end, based generally on four factors: falling production (GDP already is falling), falling real income (real disposable income is down 18 months in a row), falling real sales (slow declining trend), and falling employment/rising unemployment (not yet here- still seeing strong payroll growth).
We are seeing three of the four conditions for a NBER recession call already met. The sole hold-out is unemployment, still low at 3.5%, and payroll growth of +528,000 in July, 2022. The household report was weaker at +179,000 in July, following a decline in June of over -300,000. Employment is a lagging indicator, with household reporting leading the payroll numbers, and eventually job cuts, layoffs, and hiring freezes will hurt employment growth, along with the inability to find talent. One negative factor in our economy and affecting productivity is the level of those Not in the Labor Force, which topped 100 million in July. NBER and our textbooks both predict that unemployment will rise at least .50% during recession, which is a cost of almost a million jobs.
We do need to understand that recession or the risk of recession will not stop the Fed from raising interest rates, liquidating their bond portfolio, and reducing the money supply. M2 year-over-year growth has slowed to +5.9% in June, 2022, compared to +12.4% in December, 2021, and 21% to 25% during the pandemic months in 2020. Prior to the pandemic, M2 growth ranged from 3% to 5%, which seemed to be a steady non-inflationary pace. The Fed will keep raising rates to show their resolve to the markets that they will fight inflation or else inflationary expectations can soar pretty quickly. So far, they are relatively steady, with the 10 year Treasury and TIPs measure showing inflation at 2.48%. Meanwhile the 5 year Treasury- TIPs is 2.76%.
It is not just the US that is under threat of recession. China’s economy is declining as housing/real estate and manufacturing are under pressure. Europe is also under the gun as high prices for energy have sapped spending power. Big heat waves struck the US and Europe during July, with temperatures exceeding 100 degrees for a time. I can attest to the heat in Metz and Paris, as one day it was 100, the next was 102. Then it would cool to 98 or 99. Many areas of Europe are suffering from lack of rainfall. The Rhine River, a mainstay of all the economies along the river as well as the favorite of river cruises, is so dry in areas that ships can no longer navigate. Lack of rain is also hurting agriculture and hydroelectric plant production. Pray for rain! And pray for the grapes that will soon become wine!
What are leading indicators telling us? The biggest leading indicator of all is the stock market, with its negative performance year-to-date. The S&P 500 is down -10% and the Russell 3000 is down -11%, but have recovered from the lows in June. The stock market is certainly pointing to down times in the economy and corporate profits. Another leading indicator is the Treasury yield curve, which is currently inverted between the 2 year and the 10 year yields by -.45%. The 3 month to 10 year yield spread is still positive, by .24%, but with one more Fed rate hike will turn it negative. My preference has always been to follow the 2-10 year spread as a recession indicator, which is market determined. The Fed prefers the 3month-10 year spread, but they control the 3 month.
The index of leading economic indicators, published by the Conference Board, was down -.8% in June and was down five of six months in 2022. This bodes ill for the economy six to nine months from now, and coincides with the six to nine month lag in Fed policy. The leading inflation index, published by FIBER, gives a glimmer of hope about inflation. In May, the index turned down on a year-over-year basis for the first time in several years, and has been down three months in a row. Commodity prices have also fallen recently, contributing to the small drops in inflation. As I said, a small glimmer of hope…
Many surveys, such as ISM, S&P, and Philly Fed manufacturing and services, are showing declines in July for the Prices Paid component. University of Michigan also shows that consumers think inflation will fall after the coming years; one year inflationary expectations are at 5.0% and 5 to 10 year expectations are at 3.0%.
One silver lining of rapidly rising interest rates is the relative strength of the US Dollar versus other major currencies; the dollar has continued to be very strong and the dollar index is up +11.6% year-to-date. A strong dollar serves to keep import prices lower than they otherwise would be, and kept inflation from becoming worse. But the strong dollar has raised prices more rapidly in the rest of the world and the emerging markets are facing a crisis with high interest rates and potential defaults on debt. Foreign investors not only suffered from market declines, but their US holdings also were down from exchange rates versus the dollar. On our trip to France, the exchange rate was close to 1 to 1 between the US dollar and the Euro so we were pretty happy. As mentioned, China’s and Europe’s economies are struggling- China with a real estate crisis and declining production and Europe with an energy crisis.
And speaking of debt, the US Treasury total now exceeds $30.4 trillion, or 122.6% of GDP at the end of the second quarter of 2022. Ratios above 90% of GDP have been shown to seriously detract from GDP, which was evidence with average GDP of +2.2% to +2.3% between 2010 and 2019. Debt levels keep rising so I believe our longer-term potential will now be below 2.0%.
And a word about the housing market- it has been, in a word- devastated. Housing starts, building permits, new and existing home sales, pending home sales, and builder sentiment indices are all down sharply so far in 2022. Price changes are still near the highs of +20% year-over-year as inventories on existing homes remain very low at 3.0 months’ worth of sales. New home inventory is too high at about 9.0 months. There is no happy medium. Higher rates and recession will pull down the large price increases.
If we are not in recession already, we soon will be. The data is pointing that way and the Fed will continue to raise rates. Just think, before they had even tightened a tiny bit in March, GDP was already down. They will keep raising rates until inflation is falling substantially. They must show the markets they will fight hard. They will keep raising short-term rates, while longer-term rates keep declining in response to recession and recession risk. Even recession won’t stop the Fed, at first. But recession will stop inflation. It does every time.
Large Hadron Collider Update
Everyone’s favorite machine is back up and running! Since 2018, the Large Hadron Collider, or “LHC,” was down for maintenance and upgrades so that particles could smash at 6.8 trillion electron volts, or “TeVs,” for a total of 13.6 trillion TeVs when the protons collide. The LHC restarted on July 5, 2022 and will run for four years until being shut down for maintenance in 2026.
The LHC fires protons at each other at almost the speed of light along the 17 mile tunnel under the Swiss and French Alps, where magnetic fields move the protons around. The debris cloud when the protons collide reveals subatomic particles for study. Linear accelerators were added to strip the electrons from the protons. Also, upgrades were added to the software to sort the data that is felt to be useful for study; this is accomplished by artificial intelligence. To date, only about 10% of the data has been analyzed; this can now be raised by 3 times.
There has not been much excitement since the discovery of the Higgs Boson particle in 2012. New discoveries include new particles and scientists are attempting to explain dark matter, which makes up 95% of the universe. So hopefully, someone will tell us what this all means and what it will do for us or teach us.
Senior Vice President
Director of Treasury & Risk Management