FTR Expert Steve Graham weighs in on how things look economically as we reach the halfway point of 2022.
Let us imagine what it would be like to have fallen asleep back in December 2020 and just awakened. If you woke up near books and magazines, you would notice the titles were pessimistic– Global Recession, 40-Year High Inflation, War, Yield Curve Inversion, Markets Crash, Sky-High Oil Prices – and you might think it was Halloween, or that you were caught in some kind of economic nightmare. As you wake and look a little further, you might start to realize that some of the worst implications of these negative titles have not happened, yet. As you center yourself and calm down, you realize that most of these forebodings are still just warnings. However, it has become clear that it is a good time for self-evaluation. There have been too many shock events in rapid succession, a return of the economic monster from the 1970s, a war in Europe, and a supply shock that’s adding more inflation. We all need a little additional psychological evaluation anyway and now is a good time.
The economic story of the 21st century so far has been a story of disruptions, starting with the emergence of the COVID-19 virus that disrupted economic activity in 2020. The impact of the virus on the business cycle and its impact on the transportation grid and attendant businesses was the first big challenge of the 21st century. In the last few years, business executives have been under tremendous pressure and stress. First, the decline of about 20% of freight in 2020 came at us in an unprecedentedly short period, and that was followed by an equally quick rebound in demand that caught supply managers flat-footed at all levels of the supply chain. We didn’t see it coming, but in late 2021 another virus was sneaking into the American economy. A financial virus, not seen in force since the early 1980s, called “inflation.” This non-biological virus was considered by many executives to be their number one problem last December and their number one problem now. Who would have guessed that an economic term, thought by many to be extinct back in the 1980s, would return to haunt the U.S?
Sometime, late last year, it was becoming apparent that the inflation trouble that was supposed to be “transitory” was developing into a long-term problem. Most economists, including Federal Reserve Chair Jerome Powell, projected that we would have some increase in inflation coming out of the steep pandemic economic downfall anyway, but over time inflationary pressures would start to cool off as the supply chains caught up. This might have happened in normal times, but the sources of inflation were becoming numerous. Future economic historians will decide what combination of factors allowed inflation to return and flourish. Fiscal spending went too far. A red-hot labor market lifted worker pay the most in a generation, global supply shocks kept coming, and the war in Ukraine created food and fuel scarcities.
The latest CPI and PPI reports showed that not only is inflation alive and well, but it is also becoming entrenched. Financial markets realize that not only is inflation spreading across the economy, but it will take an extra effort to chain it up. It now appears that it will take more FMOC meetings and more tightening actions to cure inflation, and those extra actions have increased the probability that we may fall into recession. The recent stronger-than-expected CPI report laid the groundwork for the PPI report, which had the same impact of sending financial markets scrambling for cover and raising fears of recession. The difference between the two reports is: that although they are similar in reporting economic repercussions, the producer price index for final demand increased 0.8% in May, following a 0.4% increase in April and a 1.6% jump in March. Nearly two-thirds of the May increase in the PPI came from a 1.4% jump in goods prices. On an unadjusted basis, the final demand PPI was up 10.8% from a year earlier. Goods prices were largely driven by a 5.0% rise in goods energy costs. Excluding food, energy, and trade services, the PPI moved up 0.5% in May and 0.4% in April and was up 6.8% from a year earlier. As for the economic impact on financial markets, investors interpreted the message differently. In the CPI report they thought inflation was becoming embedded, by the time the PPI report was released, they knew inflation was embedded. This would make inflation harder to remove and raise the probability of a recession as a price of success.
We do expect the economy to improve, but the speed of the interest rate increases, the high inflation rates, the fact that inflation is becoming more, not less, embedded in the economy, and the signs that key components of the economy are already slowing, makes us slightly less positive that the Fed will “soft-land” the economy. The probability of a recession emerging in the next year is about even, or 50/50. Some developments could help keep the U.S. out of recession, as an end of the war in Ukraine, but that is not likely anytime soon. The war may spread in Europe and could involve U.S. and Russian troops shooting at each other. This is not a forecast, just an uncomfortable fact that this war has no end in sight.
We are entering a period of volatility. The supply chain situation is about to get better, calming demand down will bring demand back in balance with supply. Slower demand will appear as prices have been outrunning incomes for eight months. The weaker retail sales report may be the beginning of the slowdown the Fed is aiming for. The difference between a recession and skirting it will be up to the consumer. The strong labor market works for the consumer by raising wages, but it also fuels inflation. Business activity is slowing in housing, and signs of cooler demand are blowing near the nation’s factories. Some consumers will be forced to slow spending on goods just to eat. Inflation will retreat but is likely to only lose velocity slowly. That makes the Fed’s job even harder.
We are living in strange times. First, a 100-year pandemic that brought out the best and worst of humanity. Some of the policy responses could be up for debate. Should we have shut down the economy at all? Is the Chinese response correct? Here, halfway through 2022, we are still reacting to the pandemic and will be for a few more years. One thing is certain, though, that some economic terms have a reality that is real. Ignore gravity and you will fall. Ignore inflation and you aren’t going anywhere.