Executive summary
Inflation is all the rage as prices have escalated since the pandemic. Inflation, as measured by the Consumer Price Index (CPI), continued to heat up in May, up 8.6% from a year ago (slide 3). Energy prices were the primary cause, largely driven by higher gasoline prices (slide 4). Global crude oil markets are trying to reconcile the loss of Russia’s supply as a result of the European Union’s (EU) embargo on most Russian oil imports by the end of 2022. This is a game changer in our view insofar as the global crude oil production imbalances won’t be resolved anytime soon.
The pace of core CPI, which excludes food & energy, held steady in May and softened on a year-over-year basis (slide 5). Unfortunately, that will be of little solace for most people. In fact, multiple surveys show that inflation expectations are rapidly rising (slide 6).
In response to hotter inflation readings and rising inflation expectations, the Federal Reserve (Fed) hiked its target interest rate by three-quarters of a point (0.75%), the largest rate increase since 1994 (slide 7). It underscores the Fed’s nimbleness to adjust to incoming economic data, particularly hotter inflation readings. More importantly, the supersized rate increase was a dramatic shift in action, clearly showing the Fed’s determination to aggressively address inflation.
Yet, current conditions remain solid, which was the cornerstone of our “no recession” call. On slide 8, we show several key consumer metrics. We also show an indexed view of retail sales on slide 9, which illustrates the strength of this recovery compared to the prior two recessions. Similarly, on slide 10, we show that businesses also remain in good shape.
But some cracks are already appearing, especially within housing, which is very sensitive to interest rates. On slide 11, we show that higher mortgage rates have continued to cool new housing activity. Additionally, the Index of Leading Economic Indicators weakened for the third straight month (slide 12).
Alas, financial conditions have tightened substantially in the past few weeks, flipping several more of the most common recession flags, which signals a higher probability of a recession in the next 12 months (slide 13).
Our take – Tightening financial conditions have boosted recession risks
Given hotter inflation, rapidly rising inflation expectations, and—more importantly—a very hawkish stance by the Fed, the risks of U.S. recession risks in the coming 12 months have risen from even what they were just a few weeks ago.
Our view remains that demand continues to be solid currently. We are maintaining our expectations for 2.2% year-over-year growth of real gross domestic product (GDP) in 2022. Nominal GDP (not inflation adjusted) continues to be robust, with the consensus expecting 8.8% year-over-year growth for 2022, reflecting strong activity levels.
However, financial conditions have tightened substantially in a very short period. For instance, the national average for a 30-year fixed rate mortgage has nearly doubled this year, jumping to 6% from 3.3% at the start of 2022 and more than a full percentage point higher than at any time in the past decade. Housing activity has universally collapsed in the past three or four months, depending on the metric.
Thus, we must balance the solid current state of the economy with what may occur in the coming months. This is where economic outlooks get dicey. To be blunt, a recession is now a much greater possibility.
Recession odds have risen sharply due to elevated inflation and the Fed’s aggressive policy response, which risks hiking rates into a slowing economy and tightening financial conditions. There has been a dramatic increase in the Fed’s rate projections, which are roughly 1.5% higher than it expected in March (slide 7). Also, economic data has been surprising to the downside over recent months as has global growth.
Furthermore, crude oil prices are problematic. The EU’s aforementioned impending embargo on most Russian oil imports will likely keep global oil prices elevated.
There are positive offsets, including consumers flush with excess cash (slide 14), a strong job market (albeit cooling from very high levels), low debt service ratios, and a well-capitalized banking system. Yet, we must acknowledge that a recession within the next year is now much more likely than a few months ago.
What would change our view?
The consumer remains the key in our view, especially in hiring trends. More people with jobs, which come with additional income, provide the support for continued spending and growth.
Our preferred indicator is weekly jobless claims since economic weakness tends to materialize there first. At present, weekly jobless claims are hovering near 50-year lows.
Additionally, a substantial downward shift in inflation coupled with a meaningful decrease in inflation expectations would provide the Fed with the space to throttle down interest rate increases later in 2022 and into 2023.
Lastly and most obviously, loosening financial conditions, especially lower interest rates, would alleviate some of our concerns. In fact, interest rates simply treading water would help calm things.
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