Recession Ahead?

Inflation is digging in.
Investor anxiety is on the rise.
The markets are volatile.

What can the Fed do to help?

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Transcript

Recession Ahead?
Season 1: Episode 10

 Welcome to the Real Spiel with Ryan and Kurt.  This is Ryan Katz with USCF Investments. And this is Kurt Nelson with Summer Haven. 

 KATZ:  Let’s get real about investors’ concerns over inflation and potential recessionary pressures.  We’ve seen a pretty significant pullback in equites, inflation remains much higher than we have seen in quite some time.  What can the Fed do to fight inflation while also not falling into this recessionary trap? 

 NELSON:  Well, the Fed has some very powerful instruments but they are pretty blunt instruments. They have a very simple dual mandate: One is to maintain or ensure full employment in the U.S. economy.  And the second mandate is to manage inflation.  In the past they haven’t had a specific inflation target.  Maybe a decade ago they created a hard ceiling for inflation of 2% which in their minds was a mistake.  Because having a hard ceiling of 2 meant that they ensured that it was always under 2.  People have huge respect for the Fed and really believe they will do whatever it takes to manage these two goals that somewhat compete with each other.  It’s true that during the 2010’s inflation stayed pretty much below 2% during that period and the Fed in hindsight regrets that.  Because their goal is really to average 2% inflation, not keep it persistently below 2.  Chair Powell at Jackson Hole a couple of years ago relaxed that and made it clear that there’s no longer going to be a hard ceiling at 2%, it will be allowed to average 2%.  I think that accommodative stance did help inflation to ease up a bit or rise a bit but this is now much, much higher than anything the Fed wanted.  They wanted a long-term average inflation at 2%.  We are seeing prints above 8% now, well beyond their comfort zone.  

 What the Fed can do is they can raise rates.  And they are.  And they have made it clear that they will, and that includes not just the inflation hawks as well as doves in the Fed who understand that this is just a necessary reality.  Hiking rates really is putting on the brakes for the economy which means trying to deal with a shortage of supply, an overheating by dampening demand, making things tougher.  That leads to potential job losses, economic contraction, a weaker economy to deal with a shortage on supply and to try to mitigate that, smooth inflation, bring it back down.  I think the optimists right now are hopeful that by people believing the Fed have and they’re going to have an iron will here, will help in and of itself bring down inflationary expectations.  Just their conviction and belief will do this will help to slow things down a bit.  And I think there’s also hope that they don’t have to raise rates too high, that these very high prints that we see right now will moderate.  I think that we have to be really careful about putting too much credence to that though because we were told by the same Fed and by a lot of economists a year ago “don’t worry about inflation,” yes it’s gone up to 3, 4, 5% buts its transitory.  It’s all related to Covid, supply chain disruptions and will go away.  Inflation has not slowed down. It has accelerated over the last twelve months.  Transitory is no longer a word that we use anymore to describe inflation.  The short answer Ryan, is I don’t know if the Fed is going to be able to avoid some kind of economic pull back and recession in order to maintain the inflation control that they need. 

 KATZ:  Right. And we’ve seen the rates go up.  A 50-point rate hike most recently.  Many expect that there will be several other rate hikes before the end of the year and so the Fed is going to be more aggressive, we understand that.  But we also do know historically that can lead to job losses and recession and with already negative GDP growth in the first quarter of this year that looks to be continuing.  Why are they doing that and what are other options do they have to kind of protect from this recessionary track.

 NELSON:  Right now, we don’t have a job problem, labor problem.  If anything, it’s almost too hot too tight.  Unemployment is incredibly low.  We are seeing very few jobless claims. They came in under expectations, at record lows right now.  The Fed has their full employment right now.  The concern is you going to create business failures loss of jobs in order to rein in inflation.  Right now, the problem is not adequate labor or employment capability for the U.S. worker.  There are many unfilled jobs right now and wages are going up so they really do need to apply pressure on the inflation side.  The real question mark Ryan is as they apply the brakes and raise rates how quickly will they raise them, how high will they go, how long will they have to keep them elevated how much economic pain will that induce in the U.S. economy.  

 As we said before, I think they have very powerful tools but they are blunt instruments,   so I think they have to hike rates.  If you recall just last year the expectation was maybe three 25 basis point hikes during 2022.  We’ve now hiked just twice. So, 25 bps and then 50.  There’s an expectation that the Fed will continue to hike up to at least 2% by the end of the year.  So, they are going to continue these large-scale interest rate hikes each meeting until they feel that they have created the disinflationary pressure they feel they have to induce.  We are seeing that impact already in the markets.  We’ve seen things like credit spreads get wider, junk bond yields have blown out a bit, and you are seeing greater separation between things like triple C or junk bonds and investment grade and higher-grade debt so there’s much more dispersion now among those yields that asset classes generate in the market today.  We are also seeing other factors in the U.S. economy persist which are going to be inflationary for some time.  One is that we are finally seeing rents elevate.   So new apartment renters are paying much higher rents as they are establishing new leases.  We kind of thought that would happen as the Case Shiller housing price increases we’ve seen, record year over year growth eventually that flows through from actual real estate into higher rent equivalents and rent prices, a direct driver of high inflation.  Those kind of rent and rent equivalents make up a third or more of traditional CPI calculations.  So, you see we can’t overestimate their potential impact.  In the numbers that we saw for April in the PPI and CPI we saw softening of some energy prices which was welcome because other things like food costs were going up very high and I mentioned housing already.  However, what we know in the month of May is that we have kind of record fuel prices in the U.S.  The high cost of jet fuel is causing airlines to record increases in air fares so and we know that these high housing prices tend to flow through into CPI over 12-18 months so we all need to be careful not to be too optimistic and overusing that transitory word again.  I don’t know that we’ve hit peak inflation.  Only time will tell. 

 I would say by and large we’ve all underestimated the potential rise and scale of inflation’s impact on the U.S. economy and potentially on the global economy.  We keep kind of undershooting what actually comes to roost.  And people should be healthy skeptics of their own forecasting ability.  As asset allocators our job is to diversify and not necessary to predict the future.  So, I think it’s not necessary for people to call a top or a peak in inflation.  I think people should be prepared for the unexpected and the potential that it stays high for longer.   

 KATZ:  Absolutely.  And aside from the inflation you talked about wages going up, but real wages are going down because of these inflationary pressures as well.  We saw the yield curve inversion for albeit a brief time but there are definitely some things to keep an eye on as we kind of gauge these recessionary risks.  

 NELSON:  There’s a term that was coined back in the ‘70’s the last time we had steep inflation and it was called stagflation.  And that’s because of a stagnant economy while inflation was continuing to create pain.  I still think that’s a potential outcome here too so people should just be nimble and keep an open mind to different potential outcomes in the future and plan accordingly.   

 KATZ:  Absolutely. 

 This has been the Real Spiel with Ryan and Kurt.  We will talk to you next week.