Economic Update โ Second Quarter 2023
Dorothy Jaworski
Senior Vice President
Director of Treasury & Risk Management
Click to view PDF of Economic Update- Quarter 2, 2023
Inflation
Iโm writing this newsletter on a beautiful day right before Memorial Day and the unofficial start of summer. Alas, I am at my desk and not on a beach chair at the shore and Iโm searching Bloomberg for data and clues as to what will happen with interest rates, the economy, and the worst thing of all- inflation. My thoughts are that all three are going to go downโฆ
Letโs start with inflation. This evil started in 2021 when fiscal and monetary stimulus flooded bank accounts and the markets with way too much cash. And the continued flood of money continued unabated into March, 2022, when the Federal Reserve finally stopped their monthly purchases of $100 billion of bonds. They could have stopped the prior summer when they saw that inflation was not transitory, but instead they plowed another $1 trillion of inflationary stimulus into the economy. It is puzzling to say the least.
Supply chain disruptions, coupled with pent-up demand from consumers exploding after the pandemic, led to prices that soared. We experienced the highest inflation rates in over 40 years. Companies all seemed to have the power to raise prices to cover higher costs or just to expand margins and blame it on inflation. 180 million workers found themselves paying higher prices for everything, while suffering declines in their real incomes of 3% in both 2021 and 2022 and a projected 2% decline in 2023 due to inflation.
Every inflation measure that I follow has declined over the past year and most continue a steady yet frustratingly slow decline. The consumer price index, or CPI, rose +4.9% year-over-year in April, 2023 and the core (excluding food and energy) rose +5.5% y-o-y; highs were +9.1% y-o-y in June, 2022 and the core was +6.6% in September, 2022. The producer price index, or PPI, rose +2.3% y-o-y in April, 2023 and the core rose by +3.2% y-o-y; highs for the PPI were in March, 2022, at +11.7% and +9.7% y-o-y respectively.
The Federal Reserveโs inflation favorites are the personal consumption expenditures figures, or PCE. The main PCE rose by +4.2% in 1Q23 after a high of +7.0% in 2Q22. Core PCE rose by +5.0% in 1Q23 after a high of +5.6% in 1Q22. For both PCE measures, the Fedโs goal is +2.0%. Wage growth, measured using average hourly earnings, rose by +4.4% y-o-y in April, 2022 compared a recent high of +5.9% in March, 2022. The employment cost index, or ECI, was +1.0% in 4Q22 compared to +1.4% in 1Q22. Unfortunately wage and labor costs are not getting an offset from productivity, which was recently reported as -2.7% in 1Q23 following +1.6% in 4Q22. This obviously worries the Fed. Long-term inflationary expectations are in a range of +2.24% (Treasury-TIPS market) and +3.2% (University of Michigan survey).
We see how inflation started and that it is declining, however painfully slowly it creeps down. But how will inflation end?
M2 – The Secretโs Out
It has occurred to me that the Fed may have been trying to create inflation after the pandemic to offset the deflationary impacts of 2020 and to meet their new policy, established in September, 2020, to have inflation average +2.0% over time, rather than just touching +2.0% and raising rates. The supply chain disruptions and consumer behavior ruined their ill-fated experiment. They were trying to reduce money supply, or M2, growth in 2021, from +24.8% y-o-y in December, 2020, to +12.7% y-o-y in December, 2021, but it was not enough. They also made a mistake, I believe, by continuing to buy $1 trillion of bonds long after it was obvious this money was no longer needed or warranted.
And now we have an unprecedented event, not seen in any data since 1960, where M2 is falling on a year-over-year basis; in December, 2022, growth turned negative at -.9%, down from +12.7% in December, 2021. The negatives keep building and April, 2022 was down -4.6%. So we have gone from one extreme to another in the past three years. No wonder volatility reigns supreme! By the way, M2 growth has averaged +7.1% since 1960 and +6.9% in the past 20 years.
Wild swings in money supply have led to increased income, increased spending and higher prices, but an increase in velocity of money in 2022 and into 2023, from 1.14 in 4Q21, to 1.26 in 1Q23 offset some of the Fedโs efforts to bring inflation down by propping up GDP growth. Velocity is expected to begin to fall this year and, coupled with M2 that is also declining and we will ultimately get negative GDP growth from the following formula: GDP = M times V. The good news will be help for inflation falling but the bad news will be that declining velocity will hinder the Fedโs efforts to stimulate the economy once growth gets so bad they cannot ignore it.
Milton Friedman famously wrote (and like a broken record I keep repeating): โInflation is always and everywhere a monetary phenomenon.โ He also wrote that โMonetary policy works with long and variable lags.โ The decline in M2 will spell the end of inflation.
The Fed
If I learned anything from my nearly 40 years in risk management is that the Fed always goes too far. This time is no different. The Fed has raised rates by 500 basis points in the span of 13 months, leaving four bank failures (Silicon Valley, Signature, First Republic, and Credit Suisse) and 236 bankruptcies year-to-date April, 2023, in their wake. Market turmoil and volatility have been experienced by every fixed income investor, whether they are a bank, insurance company, regular company, fund, or private investor.
Letโs look at what the Fed has done so far. The Fed Funds rate was .25% in March, 2022 and in early May, 2023 was at 5.25%. I mentioned earlier that the bond buying program ended in March, 2022 and since then, bonds have been allowed to mature from the Fedโs balance sheet. Between April and August, 2022, $50 billion per month was allowed to mature, with the monthly amount accelerating to $95 billion in September, 2022 and continuing to this day. They were โeasingโ unnecessarily when buying the bonds, but now the maturity of bonds adds to the pain of tightening when they have raised interest rates so quickly. I mentioned the bank failures, mostly due to higher rates and liquidity issues, but the ripple effect is that many banks are tightening lending standards that will harm GDP growth as we move forward.
Is the Fed restrictive with its rate of 5.25%? Since the rate is above seven of the eight inflation measures that I track, with the lone exception the core CPI at +5.5%. Fed Funds is now about even with 1Q23 nominal GDP of +5.3%. So they are restrictive in my mind. On May 19, 2023, Chairman Jerome Powell stated that he would be inclined to pause at the June meeting, based on the lagged effect of cumulative rate hikes and potential bank credit tightening. I think we can add economic weakening to that list, although he doesnโt quite acknowledge it yetโฆ
Leading Indicators
Many of my favorite leading indicators look bad, which is why I always feel like a โgloom and doomster.โ I know a downturn will come, I just canโt tell you when.
Leading economic indicators, or LEI, are designed to look ahead six to nine months; the index fell -.6% in April, 2023, following a decline of -1.2% in March, and is down -8.0% year-over-year. Stocks are a major leading indicator and have rebounded 1% to 9%, with Nasdaq up +20% this year, but they have not recovered the losses from 2022 of -9% to -19% with Nasdaq falling -33%. Most regional surveys, especially the Philadelphia and New York Fed, are negative for the most recent report. The S&P Global US and ISM series are both weak. Readings on consumer sentiment by the University of Michigan are trending down. Some good news comes from the FIBER leading inflation index, which has pointed down most months for the past year and was down -7.1% y-o-y in April, 2023; there is hope for inflation to keep falling.
Corporate profits are under pressure, with the 1Q23 dropping -5.1%, following -2.0% in 4Q22, and no change in 3Q22. Spreads to Treasuries are widening for corporate bond issuance, which is never a good sign.
Recession – Just Not Yet
Real GDP weakened to +1.3% in 1Q23 from +2.6% in 4Q22 and +3.2% in 3Q22. Inventory building was high during 2022 and has since tapered off. There are many signs that recession is on the horizon- retailers are closing stores or going bankrupt (Bed, Bath & Beyond), home sales are down except for builder incentives, housing starts are down -22.3% y-o-y in April, 2023 with building permits down -21.1% y-o-y, many banks are struggling with high cost funding and are tightening credit, commercial real estate prices are down, especially offices, and consumers are substituting cheaper goods for more expensive ones.
Letโs not forget the inverted yield curve, which is a precursor to recession with a lead time of 12 to 18 months. The 10-year to 2-year spread first inverted last July and peaked on March 9th at -107 basis points; the 10-year to 3-month spread peaked at -106 basis points that same day. Currently, the 10-year to 2-year spread is -54 basis points and the 10-year to 3-month spread is -157 basis points. The forward curve on May 19th was predicting a 3-month Treasury yield of 2.95% in 18 months, down from the current yield of 5.17%. Chairman Powell often emphasized this forward curve measure, so I hope he is taking notes.
Powell is clearly frustrated that the unemployment rate is at a 60 year low of 3.4%, despite his wild tightening campaign. He mentioned in his press conference on May 3rd that job openings in March of 9,590,000 still exceeded the โsupplyโ of unemployed persons of 5,657,000 by almost 4 million. Wait! In the late 1990s and early 2000s, Maestro Greenspan taught us to focus on the pool of available workers, which are the unemployed plus those working part-time that want full-time work, or 10,928,000 in April, 2023. Maestro shows that supply is greater than demand and Powell says demand is greater than supply. Layoff announcements, as tracked by Challenger, Gray, and Christmas, are 337,411 year-to-date as of April, 2023 or four times the layoffs of the same period last year. Predictions are, that even in a mild recession, our economy could lose 1.1 million jobs if the unemployment rate rises about 1% to 4.5% in 2024. Until the rate rises above 4.0%, NBER will not declare a recession.
We have to get through the long and variable lags of Fed policy before recession strikes. M2, inflation, leading indicators, and generally weakening economic data all play a part in determining when it comes. Nothing would compare to the turmoil should the debt ceiling debate between Congressional Republicans and the White House not be resolved and a default on our once risk-free debt occur. I do believe that if a โdefaultโ occurs, it will more than likely be a delay in receiving principal and interest payments, not an outright loss of payments. We had a similar debate over the debt ceiling in 2011 and we survived that one.
So go and enjoy your summer, your vacations, and time spent with family and friends. And remember what I always say: If recession is inevitable, then recovery is just as inevitable.
Thanks for reading!
Dorothy Jaworski
Senior Vice President
Director of Treasury & Risk Management
