Inflationary Forces Driving Everything Higher for Longer
• Economic momentum slowing, recession risk rises to 50%
• Fed needs to slow demand to rein in inflation
• CNR is proactively lowering risk levels in portfolios
Many factors have led to high inflation, including supply constraints, unprecedented monetary stimulus, declines in workforce levels and the war in Ukraine impacting oil and gas prices.
Post-pandemic rapid increases in consumer and business spending have caused the economy to overheat, pushing many prices higher. The Fed’s challenge is to tighten enough to slow growth without sharply increasing unemployment, something that has historically proven very difficult to do.
We estimate there is now a 50% probability of a mild recession in 2023. Mitigating factors like healthy private sector balance sheets, rising wages and strong employment could preclude a recession or lead to any recession being short and mild. However, until the path of economic growth becomes clearer, equity and fixed income markets will likely remain vulnerable to declines, and we have continuously adjusted our asset class exposures to moderate client portfolio risk levels.
When the pandemic started, the US economy was facing the prospect of a severe recession. In response, the federal government created programs that put trillions of dollars into the hands of consumers and businesses to lessen the risks of a deep and prolonged recession. The programs achieved the intended objectives, and the US economy recovered from the pandemic quicker and stronger than many had anticipated. However, the combined effect of these efforts has also led to the highest inflation in 40 years.
Headline CPI has now reached 9.1% (chart 1), and though some categories are experiencing higher price increases than others, inflation pressures are broad-based. What is causing inflation to remain so strong?
• Oil and gas prices are rising because of the war in Ukraine and reduction in supply. The same is true for food prices.
• Goods prices are rising because of too much demand and not enough supply.
• Car prices and airline prices are rising due to strong demand and not enough capacity.
• Wages are rising due to a shortage of millions of workers.
• Rental and housing prices are rising due to low interest rates and a lack of inventory.
Most of these forces are outside the Fed’s control, and if officials prevail in the fight against inflation, employment will be key. Extreme labor shortages post-pandemic and rising prices have led workers to demand and receive higher pay increases. While wage gains are still falling behind the increase in prices, large pools of excess savings accumulated during the pandemic and low borrowing costs have helped households bridge the gap, supporting spending and keeping inflation pressures elevated.
In response, Fed officials have now embarked on their most aggressive tightening cycle in decades.
The belief is that eventually higher borrowing costs, combined with falling real wages (chart 2), will force consumers to reduce their spending and businesses in turn to slow hiring. This cooling of demand should subsequently bring about lower inflation rates. However, it will take a period of many months, lasting at least into 2023, for this sequence to play out, and if demand does not cool significantly and labor conditions stay tight, the Fed may be forced to tighten even more aggressively and risk tipping the economy into recession.
For now, we don’t think a recession is inevitable. But, executing a soft landing is difficult under the best of conditions, and Fed officials have no standard playbook for the multitude of uncertainties that exist around today’s outlook. This implies to us that a wider range of outcomes is now possible, and we have been proactively raising the defensive profiles of client portfolios by lowering exposure to growth equities and gradually increasing our commitment to investment-grade fixed income. Rest assured, we will remain agile in our decision making in order to manage client portfolios though these complex circumstances.