Crypto News: Inflation Is Here to Stay and That Makes a Recession Inevitable

With first-time home buyers getting priced out of the housing market, already elevated rental inflation will continue to dog the economy. The result will be a faster pace of rate hikes, a higher interest rate when the Fed stops and an end to hopes the US can avoid recession.

What a difference a week makes! A recession still seemed likely but avoidable only a week ago. But recent data give me pause. It's not just that a recession could happen sooner rather than later but inflation is also likely to stay high enough to force the Federal Reserve to keep raising rates just as the economy is weakening. I'm not just talking about an acceleration in the Fed's timetable — so-called front-loading -- but an increase in the overall amount of policy tightening. And that not only makes recession unavoidable but significantly increases the chances that the recession in the US starts as early as this year.

The principal culprit is housing, the main expenditure for a majority of American households. Despite the rise in mortgage rates, house prices remain elevated, crimping disposable income for home buyers. Increasingly, first time homebuyers are getting priced out of the market. And that will put upward pressure on rents. With recent consumer spending data already weak, the prospect of further tightening will be too much to bear for the US economy. The only questions will be around how deep the recession ends up being and whether the Fed will be successful in wringing inflation out of the economy before it pauses its rate hikes.

I am certainly not alone in these thoughts. Deutsche Bank's latest client survey showed "90% of respondents are expecting a US recession by end-2023, which is up from just 35%" in their December survey. What's changing is that this is starting to look more and more like a 2022 problem and not a 2023 one. And that's dangerous because the Fed isn't done with inflation yet.

The difficulty posed by the shelter component of the consumer price index comes from three sources -- its size, the delay in the transmission and the spillover between rents and home sales.

First, look at this chart from Pew Research from earlier in the year.

It shows the outsized importance of shelter on household budgets. Unless you get a major offset from food, energy, healthcare or transportation which collectively outweigh housing, any increase in shelter costs really hurts household discretionary spending. And, while oil has eased just below $100 a barrel just as recession fears grew, energy and commodities prices remain well above the levels they were before Russia invaded Ukraine, making year-over-year comparisons still unfavorable.

In April, my colleague David Wilcox wrote about how to think about the shelter inflation conundrum:

Bloomberg's model anticipates the CPI component labeled "rent of primary residence" -- capturing payments by people who rent rather than own, and constituting 7% of the overall market basket -- will accelerate from 4.4% over the 12 months ending in March to 7.4% in September. Then, assuming asking rents slow substantially, it will begin to decelerate.

So, in that telling, we should expect some relief come this fall. The upshot, of course, is that if asking rents don't slow substantially, then inflation won't slow. And the Fed will react accordingly.

Unfortunately, as my colleague Mark Cudmore has pointed out "as purchasers get priced out by higher mortgage rates, renting becomes relatively more attractive". We're already seeing clear evidence that first time homebuyers at a minimum are getting priced out.

Mark also mentioned that "as mortgage rates rise, so must rental yields over time," meaning that beyond demand for rental properties, rising mortgage costs for landlords will also drive rents higher.

All of this happens with a lag to actual policy because most rents in the US get set annually. So today's higher mortgage costs ripple through over the course of an entire year and beyond.

This is also distressing for families that have to make hard choices about savings, discretionary spending and credit given how shelter costs are rising. Anecdotal evidence even shows rent inflation leading to rising homelessness. The Fed has a mandate to stamp out inflation. But its major — and very blunt — instrument is interest rate hikes. That means even more pain is to come over the next year.

7.4%

The projected level of shelter inflation in September 2022

Here's what we have to consider as the economy develops over the back half of the year.

The Fed has to decide how much front-loading of policy — hikes in jumbo sizes — it wants to do in order to keep inflation expectations anchored. It is accelerating its rate increase pace with the hopes of getting to a reasonably neutral or even restrictive level before the months-long high levels of inflation permanently alter the psychology of consumers and businesses.

At some point, this tightening of policy will put so much downward pressure on growth that the Fed will fear recession has set in. But what will the level of inflation be when that occurs? And how high will interest rates be? Those questions matter regarding how far the Fed goes even if its policies are hurting the economy and employment.

For example, I've said initial jobless claims could be so high by November that the income loss over the past year will be enough to tip the economy into recession. That is now likely to be the case given what I anticipate the Fed to do. If inflation is still running at 6% by then and the Fed has only raised rates to 3%, it is likely it could become even more restrictive. If it doesn't, inflation could remain elevated at 4 or 5% even after a recession, allowing the psychology of inflation to anchor itself in the economy.

In this scenario, the Fed will raise its target Fed funds interest rate beyond what's currently anticipated. We could get to a point early next year where the Fed is at 4.5% and inflation is at 4.5% and they call it a day. That's certainly higher than what markets expect and would still leave inflation above the Fed's target. But the economic pain of higher-than-expected rates could cause the Fed to stop short.

I think it's unlikely that the Fed will stop before inflation has come down closer to its 2% target, say 3.5%, or before the fed funds rate exceeds the rate of inflation. In both cases, they could consider their work done. By then, the economy could be in a deep recession.

The US bond market is already sniffing out the greater potential for recession. Ten-year yields peaked near 3.50% and have since collapsed seventy basis points. The Fed's favorite market measure of recession -- the near-term forward spread that measures the difference between the 3-month Treasury and the rate reflecting what the market expects the 3-month rate to be in 18-months — has dropped from as wide as 2.70 percentage points in early April to just under 1.20 points. Other major duration spreads — the differential between the 2 and 10 year yields, between 2 and 5 year yields and between 5 and 30 year — have turned negative. Those are all market signals of an impending recession.

Moreover, every major economy -- the UK, Canada, the Eurozone, South Korea and Japan — is under threat due to receding fiscal and monetary stimulus globally. This is happening as they fight against inflation which still hasn't peaked in North America or Western Europe.

So arguably, the market's recession signals aren't strong enough or they reflect an unrealistic expectation of Fed capitulation in the fight against inflation to prevent a recession. On Friday and again today, as fears of a recession increased, two year Treasury yields plunged, suggesting bets increased that the Fed would ease its tightening cycle.

When you look at economists' GDP forecasts and equity market expectations for S&P 500 earnings, there is an equal lack of realism. My expectation is that economic and earnings growth expectations will get cut aggressively. That gets you to an S&P 500 index at 3200 due to margin mean reversion alone. So this outcome is extremely negative for risk assets.

I also expect duration spreads to invert as the market adjusts to the amount of tightening the Fed will eventually do. If the Fed is at 4.5% on its overnight target rate early in 2023, for example, the 10-year could be at 4%, with the 2-year somewhere in between. Longer duration Treasuries will outperform in this scenario.

The data point that bothers me the most in all of this is the GDPNow number that the Atlanta Fed releases. It's like a pace monitor that tells us approximately what the full quarter would look like if it ended based on the economic data released up to the present. And the GDPNow number for 2Q 2022 went negative last week.

The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2022 is -2.1 percent on July 1, down from -1.0 percent on June 30.

That means a recession may have already started, at least based on the definition of two negative back-to-back quarters. If that were true, the Fed would have been tightening the monetary tourniquet while the economy was already decelerating.

But there is a silver lining in all of this in that there is still a shortage of workers. Even after some economic pain and job losses, my hope is that the labor market will be in decent shape, enough to keep wage growth high and to make sure the more marginalized laborers in the workforce have a shot at getting back onto the economic ladder. We're in a fundamentally different position in that regard to where we've been for the past two decades.

The Fed has to be extremely careful though, because in the recession that began in 2001, the headline rate of unemployment ended 2.5 percentage points higher than the low in 2000. Just because we have a low rate of unemployment now doesn't mean that employment cannot rise substantially if the Fed over-tightens.

But Fed caution is a double-edged sword because inflation is so high. Even if inflation remains elevated despite the Fed's actions, the Fed might be tempted to ease due to a fear of a recession, as markets hinted on Friday. That would leave open the risk that inflation becomes embedded, forcing the Fed to act again in short order, shortening the business cycle and hurting earnings and earnings multiples. That's what we saw in the double dip recession in the early 1980s.

I do think that there is fundamentally less room for companies to cut physical capital and human capital investment than in any business cycle I have personally witnessed. And, again that's a good thing for workers. It's not a great thing for corporate profit margins though. But that's a topic to explore another day.

"When people begin anticipating inflation, it doesn't do you any good anymore, because any benefit of inflation comes from the fact that you do better than you thought you were going to do."

Paul Volcker

Federal Reserve Chair, 1979-1987

John Authers says housing market disquiet is growing
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