Brian Jacobsen, Janet Rilling, and Jeff Weaver provide perspective on the U.S. economy—and key indicators we monitor to gauge the potential for a recession—as we look ahead to the FOMC announcement on June 15, 2022.
Fed: Full-speed ahead or throttling it back?
The Federal Reserve (Fed) is looking for “clear and convincing evidence” that inflation is turning. Nothing is clear or convincing until well after the fact. Does the Fed run the risk of being too late to recognize the economy has slowed, much like it was too late to recognize that inflation has skyrocketed? Maybe—but probably not.
Fed Chair Powell misjudged how high inflation would run and how long it would stick around. In August 2020, the Fed introduced its Flexible Average Inflation Targeting (FAIT) strategy, where it said it would tolerate above-target inflation after a period in which inflation fell short of the Fed’s 2% target. Inflation began to spin out of control as new waves of COVID-19 didn’t destroy demand like the Fed had feared and supply chains didn’t heal as the Fed had hoped.
Since late 2021, the Fed has hiked only twice, and it’s just beginning to shrink its balance sheet. So, it hasn’t really done much. Yet, it has said a lot, and markets have already priced in rate hikes and balance-sheet reduction. Credit spreads have widened, short-term yields have risen, and equity markets have fallen. The market has already done a lot to price in the potential risks that growth will slow and inflation will only gradually come down.
FAIT wasn’t the cause of the high inflation we have, but will the Fed’s waiting for a clear and convincing turn in inflation make a recession a foregone conclusion? Let’s check the evidence:
- The yield curve—the difference between long-term yields and short-term yields—is very steep on the short end but very flat on the long end. Overnight rates are quite a bit lower than the 2-year Treasury yield, but there isn’t a lot of breathing room between the 2-year and the 10-year yields. Practically speaking, we know overnight rates should move higher if the Fed goes ahead with its rate-hiking plans. That will likely flatten the short end of the yield curve. The longer end of the curve can be swung around by all sorts of investors’ hopes and fears.
- While credit spreads have widened, they’ve just gotten back to average. It’s not the level of spreads, nor the level of yields, that typically signals recession. It’s the rate of change that can signal an abrupt tightening of financial conditions. On that measure, recession risks have risen.
- Small-cap value stocks can be the proverbial canary in the coal mine. A lot of small-cap companies aren’t profitable, which makes active stock selection really important in that space. Low valuations can signal financial distress and poor growth prospects. When small-cap value stock returns trail the rise in inflation, that can be a sign the market is anticipating a recession.
- Price pressures have risen faster than production. This tends to be a bad sign for profits and future economic growth. Thus far, companies have been able to maintain their margins by passing on cost increases to consumers or by running more efficiently. But, eventually, consumers won’t tolerate price increases if their wages aren’t rising in tandem, and there are a limited number of cost-cutting measures businesses can implement before they need to stop or slow hiring.
- Perhaps the two redeeming features of the current economy are the strength of consumer spending and the low unemployment rate that hasn’t begun moving materially higher. It typically takes a 0.5% increase in the unemployment rate before a recession comes into view on the horizon.
The benefit of hindsight makes it easy to “Monday morning quarterback” what the Fed got wrong. But based on the information it had at the time, the Fed thought the chances were good that inflation would fall and the economy could continue to use the support from asset purchases and low rates. In late 2021, the Fed recognized things weren’t evolving as they’d anticipated and struck a different tone—a more hawkish one. Now, the market is more like “Saturday evening quarterbacking” what the Fed will likely get wrong.
The constellation of indicators we like to watch point to a heightened risk of recession—but not a certainty of recession within the next year. The Fed sees that same evidence, too. The ideal outcome is a soft landing, where a series of rate hikes can reverse the inflation trend without choking off growth. Given that it was slow to respond to the inflation data in 2021, the Fed may not be as slow to respond to the growth data in 2022. The bar for “clear and convincing evidence” might be lower when it comes to looking for a recession than it was when it came to looking for inflation.
There’s a very wide range of outcomes related to the Fed’s actions. In our view, that high level of uncertainty argues for diversification and a more tactical mindset. The Treasury market, arguably, has done a lot to price in higher rates. Credit markets were on track to begin pricing in recession risk as spreads widened notably in mid-May. However, coming into early June, spreads have reversed much of that widening. In our view, credit remains vulnerable to any rise in recession fears even if the Fed doesn’t drive the economy into a recession.
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