Best case scenario
Inflation cooling but labor market remains healthy.
Inflation has begun to come off the boil over the past several months in response to the Federal Reserve's aggressive increase of the fed funds rate last year. It raised the target range from the zero bound to a range of 4.25-4.5% and started to shrink its boated balance sheet.
- Consumer Price Index (CPI) Nominal retail CPI inflation spiked from 1.4% year over year (y/y) in January 2021 to a 41-year high of 9.1% in June 2022, but it has since fallen to 6.5% in December. Core CPI (which excludes food and energy prices) eased from a 40-year high of 6.6% in September to 5.7% in December.
- Producer Price Inflation (PPI) Nominal wholesale PPI inflation hit a record 11.7% y/y in March 2022 and has slowed to 7.4% in November. Core PPI peaked at a record 9.7% in March and has slowed to 6.3% in November.
- Personal Consumption Expenditures (PCE) Index Nominal PCE inflation hit a 41-year high of 7% y/y in June 2022 and has slowed to 5.5% in November. Core PCE (the Fed’s preferred measure of inflation) peaked at a 39-year high of 5.3% y/y in March and has slowed to 4.7% in November. The Fed’s oft-stated target for this metric is 2%, a level we expect to be achieved over the next two years.
Resilient labor market But as the Fed has doggedly withdrawn accommodation to combat the worst inflation in four decades, the unemployment rate remains at a 53-year low at 3.5%. That’s great news, as the Fed fully expects that its hawkish Phillips Curve trade-off will result in unemployment rising to 4.6% over the course of this year, according to its own summary of economic projections published last month.
What’s a central bank to do? While the Fed downshifted at its last policy-setting meeting in December to a less aggressive half-point rate hike after four consecutive 75-basis point rate hikes (June, July, September, and November), it doesn’t appear it’s done quite yet. Despite this nascent improvement, we believe policymakers want to maintain their inflation-fighting credibility with financial markets. So, we fully expect them to raise rates by another half point at their meeting in February and by a quarter point in March. But if they instead throttle down to a quarter-point hike in February, we expect them to add quarter-point hikes in March and May. Either way, they will have orchestrated a terminal rate in a range of 5-5.25%. We expect the Fed to pause at that level until 2024.
Mission accomplished? But the Fed is clearly willing to pay the price of weaker economic growth and higher unemployment to quell inflation. The growing risk, of course, is that the economy is on a glide path into recession in the next two years. While the labor market remains healthy, other parts of the economy are slowing, such as housing, consumer spending and manufacturing.
Housing recession As mortgage rates have more than doubled from 3% to 7.35% over the past year, the housing market index has plummeted from a peak of 90 in November 2020 to a two-and-a-half year low of 31 in December 2022. A collapse of that sheer magnitude is typically associated with a recession. Pending home sales have fallen in 17 of the past 18 months, and existing home sales (which account for 86% of the total housing market) have declined for 10 consecutive months through November.
Santa's bag half the size In October and November, the first two months of the critically important four-month (October through January) holiday shopping season, Christmas spending rose a combined 7.5% y/y. That’s less than half the robust 16.4% y/y growth during Christmas 2021, although still above the average 4.2% y/y growth in holiday sales over the previous 10 years (within a range of 2.2% to 6.6%). But it is in line with the 6-8% sales growth projected by the National Retail Federation during November and December, and the 4-6% sales growth the accounting firm Deloitte forecast for the full period of November through January.
Manufacturing slows The ISM manufacturing index plummeted from a 38-year high of 63.7 in March 2021 to a two-and-a-half year low of 48.4 in December 2022. We’re in economic contraction territory, and we’re inching closer to a recession reading of 45. All six of the regional Fed manufacturing indexes we monitor have fallen back to 2-year lows over the past 18 months.
Confidence mixed Consumer confidence (Michigan Sentiment and the Conference Board) has perked over the past two months due to lower inflation, but business confidence (NFIB small business optimism index) surprisingly plunged in December due to recession worries and declining corporate profits.
Leading Economic Indicators have now declined nine months in a row and a dozen times over the past 13 months, dragging the Conference Board Composite Index down to a 19-month low. Combined with a current 73-basis point 2/10 yield-curve inversion, it suggests an elevated risk of recession.
Adjusting our GDP estimates The equity, fixed-income and liquidity investment professionals who comprise Federated Hermes’ macroeconomic policy committee met on Friday to discuss the cooling of inflation and the trajectory of the Fed’s response:
- The Commerce Department recently revised third quarter GDP growth from 2.9% to 3.2%; the second quarter’s growth rate was -0.6%.
- The Fed added another 75-basis point rate hike in November and a half-point increase in December. While it appears Christmas spending slowed to half of last year’s strong season, the pace was healthy. Fourth quarter 2022 GDP will be flashed January 26, and we raised our estimate from 1.2% to 2.3%; Blue Chip consensus raised its from 0.4% to 1.7% (in a range of 0.3% to 2.8%); the Atlanta Fed’s GDPNow tracker fell from 4.3% to 4.1%; and the Bloomberg consensus is 3.5%.
- We raised our full-year 2022 GDP projection from 1.9% to 2%; Blue Chip increased its from 1.8% to 1.9% (within a range of 1.6% to 2%).
- Core CPI inflation finished 2022 at 5.7% (it hit a 40-year high of 6.6% in September 2022). We reduced our full-year 2022 forecast for core PCE inflation from 5% to 4.7% (it reached a 39-year high of 5.3% in March 2022).
- We increased our first quarter 2023 GDP estimate from 0.2% to 0.5%; Blue Chip consensus raised its from -0.6% to -0.5% (within a range of -2.2% to 1.1%).
- We revised our second quarter 2023 GDP projection up a tick from -0.4% to -0.3%; Blue Chip reduced its from -0.3% to -0.9% (within a range of -2.5% to 1%).
- Our third quarter 2023 GDP estimate is unchanged at -1.2%; Blue Chip lowered its from 0.4% to 0% (within a range of -2.1% to 1.9%).
- We raised our fourth quarter of 2023 GDP forecast from -1.2% to -0.9%; Blue Chip’s was unchanged at 0.9% (within a range of -1.1% to 2.3%).
- These adjustments raised our full-year 2023 GDP estimate from 0.1% to 0.6%; Blue Chip raised its from 0.2% to 0.5% (within a range of -0.3% to 1.5%).
- We reduced our full-year 2023 forecast for core CPI inflation from 3.9% to 3.7% and for core PCE inflation from 3.4% to 3.3%.