When Will Inflation Fighting Fed Worry About Recession

Stimulative Western Governments and Central Banks in 2021 ignited the global consumption bonfire that created the 41-year inflation peaks we are witnessing today. For over a decade prior to the 2020 – 2022 Covid recovery plan, it appeared that no amount of stimulus could keep inflation above 2%. Today, Consumer price inflation is rising at an 8.6% clip while Producer prices are soaring 10.8% over the past year. 

The Government has abstained from stimulating energy and food production to counter inflation and as a consequence wages are now contracting at a record 3% rate. While the Fed is late to the inflation fighting party, it’s now their mission to gain credibility and tighten credit to slow the economy.

Belatedly, our Central Bank is now restricting economic activity by draining the punch bowl with higher rates and fewer reserves for banks to borrow. All-time record high gasoline prices, negative wage growth and a parabolic jump in mortgage rates have most consumers and economists forecasting some degree of Recession as the Fed inflation battle ends. In 1974, economist Julius Shiskin cemented the unofficial interpretation of a Recession, defined as an economy experiencing two consecutive quarters of economic (GDP) contraction. This arbitrary view has worked fairly well in coinciding with official consensus Recessions, for which the National Bureau of Economic Research (NBER) is the official arbiter.  Currently 70% of economists expect a US Recession to be declared in 2023. While the definition is variable, the NBER already has some of the ingredients in place for declaring that a Recession has begun due to the near zero growth in GDP and contracting incomes during the first half of 2022. The main reason to be more optimistic that a serious Recession can be avoided over the next year is due to the historic shortfall in labor supply and depleted inventories. We are a long way from sharply rising unemployment and overstocked stores that are hallmarks of Recession.

In past cycles the 10- and 30-Year Treasury Yields and the Federal Funds Rate have approached the CPI inflation rate peaks. Those wondering if the Fed can afford to hike rates further need to understand that until energy prices and the general inflation indices fall decisively and unemployment rises sharply, our Central Bank will risk a contracting economy with even higher interest rates. The record number of unfilled jobs provides the Fed with a healthy buffer to risk higher rates and tighter credit conditions. Until then, stock and bond investors need to stay buckled up and expect rallies to be temporary. We had hoped for more stability in June and a rally into July before the next wave lower, although supply chain shortages are worsening and economic risk remains to the downside regardless of the short-term timing.

There are early signs from the manufacturing sector that inflation is peaking. Once this trend becomes more acute, Bonds and Stocks will rally on the hopes that the Fed will take some of the pressure off the credit tightening brakes.

Our view is that inflation is hitting a plateau this summer that will become more obvious when the August/September CPI data arrives in September/October. While the energy crisis can be manipulated much further due to Russian energy restrictions, we expect falling energy consumption into Q4 from a slower economy and high inflation will begin to bring supply and demand closer to balance. Economic cycles forecast that the highest risk of Recession and labor over supply will be during the late 2023 to early 2024 timeframe. It’s during this period we project inflation will fall back into the Fed’s range under 3% and consumers will once again see gasoline prices well under $4 a gallon on average (currently $5 and rising). Stocks will rally once they sense that the inflation fighting Fed is ready to suit up for battling the growing fears of a Recession in 2023 with supportive monetary policies. The all clear for stock investors also requires a significant decline in Oil, and Natural gas prices into a cycle low that currently appears to be a long way from here.

*News alert: June 26th to 28th the G7 will meet. One major item that Italy and the US are attempting to bring up for proposal is a price cap edict on Russian Oil and Gas exports to G7 countries (or perhaps world Oil caps). Globally, Oil  is priced in US Dollars. Should a cap on Russian energy become reality, it’s likely that Russia would continue tightening the spigots, possibly cutting off Europe’s lifeline. They have “temporarily” shut off 40% of Natural Gas flows to Germany in recent days due to “repair” issues and if Russia has enough alternate Buyers, they may choose to send Germany and or Europe into a severe Recession with a total energy embargo. Currently, Russia holds the trump cards, as Europe and the US have shown a lack of will power to increase energy and food  production to counter Putin’s War and the levers he controls. Government price caps in general  emblematize a lack of acumen with regard to basic economic principles. In this case, a price cap proposal such as rumored, would be exacerbated by a hostile producer with Global leverage and risk even larger energy shortages and eventual inflation.

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