The US economy was confused by a wave of high inflation, with employment remaining strong last year despite inflation soaring to a 40-year high. Now the markets are signaling that the turmoil is coming to an end and something worse is coming in its place.
The Federal Reserve, the BFF of the markets for much of the past decade, is now more of an enemy. On September 21, as expected, the Fed raised interest rates by three-quarters of a percent. It also hinted at more aggressive rate hikes ahead.
This is the hard-core Fed that may need to do some economic damage to avoid worse damage that would come from runaway inflation.
“The odds of a soft landing are likely to decline the more restrictive or restrictive the policy is for longer,” Federal Reserve Chairman Jerome Powell said on Sept. 21.
Here’s what he means: With inflation still uncomfortably high, the Fed will have to keep raising interest rates. That increases the likelihood of a recession, including the likelihood that more people will lose their jobs and experience the ravages of unemployment.
It hasn’t happened yet.
Inflation peaked at 9% in June and fell to 8.2%. The unemployment rate remains close to a cyclical low at 3.7%.
But inflation isn’t falling fast enough for the Fed, which has pushed short-term interest rates from about 0 to about 3%. Long-term interest rates on consumer and business loans increased by comparable margins. As interest rates rise and borrowing becomes more expensive, spending and hiring tend to decrease. Weaker demand relieves pressure on prices, pushing inflation down.
A soft landing would be a consistent fall in inflation that does not distort the labor market or put too much pressure on economic growth. The stock market recovered from July to August as falling oil and gasoline prices and a few other factors suggested that inflation would decline without drastic action by the Fed. Investors are betting on a soft landing.
But inflation in August came surprisingly high, pushing the Fed into shock-and-awe mode. ‘Fed on the warpath,’ Bank of American warned customers on Sept. 23. ‘Overshoot and hard landing probably. Central banks will take steps until something breaks.”
Like other forecasters, BofA lowered its outlook for the economy in the wake of inflation news and the Fed’s shift towards even tighter monetary policy. The bank now expects a recession in the first half of 2023, with unemployment rising from 3.7% to 5.6% by the end of next year.
“The Fed’s actions suggest to us that it is committed to reducing inflation and appears willing to accept some deterioration in labor market conditions,” BofA researchers wrote. “We think our forecast is consistent with the Fed taking ‘strong measures’ to slow demand, by doing more than less.”
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Other recession indicators start flashing.
The spread between 10-year government bond yields and 2-year government bond yields, also known as the yield curve, has been negative since July, meaning that short-term rates are higher than longer-term rates. An inverted yield curve, as it is known, is a condition that usually occurs before a recession, with very few false positives.
Moody’s Analytics points out that a measure of change in unemployment, known as the Sahm rule, could also indicate that a recession is imminent. If unemployment rises, as the Federal Reserve’s latest forecast suggests, the pace of deterioration could reach a threshold typically associated with a recession in May next year. Moody’s Analytics thinks the US economy can narrowly avert a downturn, but also says that “making a soft landing … is an increasingly weak prospect.”
The markets have certainly gone gloomy. Stocks fell over the past month, with the S&P 500 stock index falling a painful 13% since mid-August. On September 23, it hit its lowest level since late 2020, when the economy was still Covid-bound and vaccines were not yet available. Oil prices fell below $80 a barrel, although inventories are tight, pointing to concerns about a recession not just in the US but globally.
The political implications likely depend on the timing of the hard landing.
Consumer confidence has even improved from the bleak levels of early summer. That’s because of the massive drop in gas prices, which seems to affect confidence more than just about anything. President Biden’s approval rating rose as gas prices fell.
Biden seems to understand the correlation between gas prices and presidential popularity. His plan to pull a million barrels of oil a day from the national reserve was set to end in October, but the Energy Department recently said it will release another 10 million barrels in November.
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It must be a coincidence that the midterm elections are on November 8.
The market sell-off appears to be a repricing of lower assets ahead of a recession that may not happen for a few more months. The Fed could raise rates by another point or more until the end of the year, then take a break and see what happens.
If there is a hard landing and a recession, that should lick inflation, although unemployment would worsen. Some economists think the Fed will cut rates again by the end of 2023 to fight the recession it could eventually cause. Whether the landing is soft or hard, you need to get back in the air.
Rick Newman is a columnist for Yahoo Finance. Follow him on Twitter @rickjnewman
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