Inflation or Recession? The Fed Has a Choice to Make.
Dimitri Delis, Ph.D, Chief Portfolio Strategist at Piper Sandler
Is High Inflation Sustainable?
- Services inflation is driving inflation higher. Inflation peaked in June. Goods, Food, and Energy inflation have all already started to decline or will soon.
- Shelter costs make up a large portion of core services inflation. Real-time indicators show shelter-related costs have likely peaked, and shelter inflation should start to decline in March.
- Supply chains have improved substantially, and shipping costs are back down to pre-pandemic levels.
- Declining M2 money supply should stifle inflation.
- Based on past history when inflation increased over 10%, Consumer Price Index (CPI) should decline roughly 0.3% per month in 2023.
Are Interest Rates Near Peak Levels?
- The Fed is indicating they will increase their benchmark rate another 75 basis points in 2023, and then cut rates by 100 basis points in 2024. The market is pricing in roughly 50 more basis points of rate increases, followed by 50 basis points of interest rate cuts before year-end 2023, and more cuts in 2024.
- The “Taylor Rule” implies, if the Fed raises rates by 25 basis points at their next meeting in March, monetary policy will be considered restrictive. Typically, this is roughly where they end their rate hiking cycle. The Taylor Rule’s formula ties the Fed’s key interest rate policy instrument, the federal funds rate, to two factors: the difference between the actual and targeted inflation rates and that between the desired and apparent growth in the real Gross Domestic Product (GDP).
- Yields tend to peak at the same time the Fed stops raising interest rates.
- Longer-term rates may stay lower even if the Fed keeps raising their benchmark rate as the yield curve inverts further.
- Short-, mid-, and long-term rates dropped six and twelve months following the last Fed rate hike at the end of each tightening cycle back to 1974.
Long-term Rates to Remain Low
- Since CPI stayed within a steady and predictable range over the last three decades, long-term rates have trended lower.
- Recently, inflation broke above its long-term range as well as long-term rates.
- As inflation declines back into its long-term range, so should long-term rates.
- Other correlated indicators suggest the 10-year Treasury yields may have already peaked.
- A stock market correction should help to drive inflation lower.
Gauging the Next Recession
- Whenever the 3-month/10-year and 2-year/10-year yield curves both inverted in the past, there was a recession soon thereafter. Both of these curves are currently inverted.
- Consumer confidence is very depressed right now, which has also occurred prior to most recessions in the past.
- The Leading Indicators Index has never declined this much without a recession occuring.
- Unemployment typically hits its cyclical low prior to the onset of recessions. Unemployment has likely hit its low in this cycle.
- Consumers are unlikely to get more optimistic, and declining optimism should lead to higher unemployment.
The Debt Ceiling Standoff
- Since 2008, Federal debt has more than trippled.
- Debt ceiling should be breached between July and November.
- In the 2011 debt ceiling episode, rates and stocks dropped before and following the suspension of the debt limit.
- In the 2013 episode, rates and stock first dropped, but then rose before and after the debt limit was suspended.
- U.S. sovereign credit risk has spiked to near record highs. In 2011 and 2013, this occurred two to three days before the debt ceiling was hit. Now, it is occuring months before it is happening.
- Mortgage rates are at 20-year highs, and affordability has declined dramatically.
- Homebuying and homebuilding confidence is at historically low levels.
- Housing price growth should slow, but existing home supply is still very low, and shows prices are not too far out of line.
- Home price appreciation has varied greatly across different cities and regions of the country.
- Cities, having a high median home price to median household income ratio, are most susceptible to outright home price declines. Therefore, there may be regional hosuing bubbles, not a national housing bubble.
Addendum: Deflating the Equity Bubble
- U.S. equities still look expensive compared to hourly earnings and GDP.
- Quantitative easing from central banks around the globe have supported equities.
- Equities may fall back in line with corporate profits some, but, if history continues, the Fed would likely start easing financial conditions which would likely save equities from further downside.
Sources: Piper Sandler, BLS, Zillow, Apartment List, Bloomberg, Federal Reserve, Consumer Board, FRED, NAR, Conference Board, NAHB, S&P Caswe Shiller
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