The U.S. economy is currently suffering from high inflation; it has risen to the highest rate in 40 years, which has brought many bad memories back to everyone's minds to the recession of 1970 and 1980 and everyone began to demand the U.S. government and the U.S. Federal Bank to take real actions to control inflation pressuring citizens in their daily lives.
At the Fed meeting in March 2022, the Fed announced a 0.25 percent rate hike for the first time since 2018 and announced six more hikes in 2022 until the interest rate reaches 2 percent by the end of this year; however, there was much criticism from Fed Governor Jerome Powell that he is way behind the curve and should be more hawkish to control inflation, which reached 7.9 percent in February and is expected to reach 8.2 percent in March due to the sharp fall in energy prices that accompanied the Russian-Ukrainian crisis. Federal Reserve Chair Jerome Powell said earlier last week that the Fed could raise rates by 0.50 percentage points in the coming months if the Fed decided more forceful action was necessary to control inflation. Federal Reserve Bank of St. Louis’ President James Bullard, regarded as the most hawkish Fed policymaker, continues to call for the policy rate to rise to above 3% this year That led Goldman Sachs to expect the U.S. Federal Reserve to raise interest rates by 50 basis points each at its May and June meetings, following hawkish remarks by the central bank's chair Jerome Powell.
There have been a lot of questions whether the Fed can tighten its policy to curb rising inflation, maintain economic growth and unemployment rates below 3.5 percent, what Jerome Powell calls soft-landing, or that recession or stagnation has become inevitable for the U.S. economy to control current inflation. Unfortunately, economic solutions cannot be considered white or black; there is a prevailing debate between which side will the economy be on: Can the U.S. economy face current inflation without reaching recession or stagnation? But before that, we must understand the difference between a recession and inflationary stagnation.
The definition of what constitutes a U.S. recession is somewhat flexible, but two successive quarters of negative economic growth is the standard definition. The Great Recession, for instance, lasted from December 2007 until June 2009 and resulted in a 4.3% decline in the gross domestic product (GDP). It was one of the largest and deepest recessions in modern history. And while few economists are predicting negative GDP growth right now, analysts are lowering their growth forecasts. Goldman Sachs recently cut its outlook for 2022 U.S. GDP from +2% to +1.75%, owing to higher oil prices as a result of Russia’s war in Ukraine. This forecast dovetails with the Atlanta Federal Reserve Bank’s GDPNow outlook. Furthermore, the Fed lowered its expectations for 2022 GDP growth from +4% to +2.8%.
Stagflation is characterized by slow economic growth and relatively high unemployment—or economic stagnation—which is at the same time accompanied by rising prices (i.e. inflation). Stagflation can be alternatively defined as a period of inflation combined with a decline in the gross domestic product (GDP). Inflation doubled in 1973 and hit double digits in 1974; unemployment hit 9% by May 1975.
There’s a serious debate as to the future of the U.S economy, and experts on both sides of the argument have strong evidence to back up their claims.
Recession signals flashing red:
- The bond market’s favorite recession signal, the yield curve, is the spread between short-term government bond yields, most notably the 2-year Treasury, and longer-term bond rates like the 10-year Treasury. As that spread diminishes, investors worry that the yield curve could eventually invert, meaning that short-term rates would be higher than long-term yields. As of Friday, the difference was just 0.25%, with the 10-year yield at around 2% and the 2-year yielding 1.75%. The gap widened a bit on Friday, as the 10-year rose to 2.48% and the 2-year yield was up to about 2.28%, making the spread 0.20%. When investors want higher rates for short-term bonds, it's an indication that bondholders are nervous. Typically, rates for long-term bonds are higher because you have to wait longer to get paid back. An inverted yield curve has often been a potential recession signal. The yield curve inverted in 2019 before the 2020 Covid-induced recession. It also did so in 2007 before the 2008 Global Financial Crisis/Great Recession. It also inverted in early 2000 right before the dot-com/tech stock meltdown.
- In February, the famous University of Michigan survey of consumers fell a stunning 19.7% year-over-year to its worst level in a decade. Largely attributed to weakening personal financial prospects caused by rising inflation. According to the latest CNBC Fed Survey, the probability of a recession in the U.S. was raised to 33% in the next 12 months, up 10 percentage points from the Feb. 1 survey. The chance of a recession in Europe stands at 50%.
- Billionaires like Carl Icahn, Bill Gross, and Jeff Gundlach argue stagflation, a recession, or “even worse” could be in the cards as the Federal Reserve attempts to cool inflation with interest rate hikes.
Recession signals that remain in the green:
- “The 10-year/2-year gap is one part of the yield curve. However, another important part of the curve, the 10-year/3-month, has steepened and If the past 30 years are of any guide, both parts of the curve need to flatten and invert before we are at risk of recession.
- Powell preferred a different measure of the yield curve that isn’t yet flashing a warning sign. Research by staff in the Federal Reserve system advises looking at the first 18 months of the yield curve. That slice of the curve, as measured by the spread between the current three-month Treasury bill rate and the 18 months, bets on where that will be in 18 months derived from the forwards market which is now about 229 basis points, according to data compiled by Bloomberg.
- The severity of commodity prices: Of all the kinds of inflation, commodity-based increases tend to be the most self-curing sort, and thus temporary. Usually, higher prices rapidly lead to greater production, which is often simultaneously met with lower demand. Morgan Stanley Research Chief Cross-Asset Strategist Andrew Sheets notes that the per-barrel oil price, when adjusted for aggregate inflation, remains well below that seen in the 1970s and 1980s, in 2006, and as recently as 2012. Similarly, relative to real assets such as gold and copper, Brent oil is still priced around its 25-year average
- The current trend in energy prices is estimated to deliver a $200 billion hit to U.S. consumption, or $1,600 per household, for the year. That figure is noteworthy, but it pales against estimated excess U.S. household savings of up to $2 trillion. Although inflation is still outpacing wage gains, Morgan Stanley economists expect the trend to flip by midyear, another pillar that could help overall demand and support continued strength in spending.
- Industrial production is a key indicator of economic strength used by economists to determine if a recession is incoming. And in February, total industrial production in the U.S. rose 0.5% to a level that is 103.6% above the 2017 average and 7.5% above what it was at this time last year, Federal Reserve data shows. The US purchasing managers’ index (PMI), which tracks sentiment among buyers who work for manufacturing and construction firms, remains also strong. The figure came in at 57.3 last month, that’s more than 6% higher than the U.S. average over the last decade. Economic growth will slow this year from the “unsustainable” level it achieved last year, said Dana Peterson, chief economist at The Conference Board. That growth was juiced by COVID vaccinations, the economy reopening, government relief checks, and another fiscal stimulus. “An economy like the U.S. could grow at 2% to 2.5% and be just fine,” she said. That’s the Conference Board’s prediction for next year, which she said would be “quite robust, and that’s also an environment that includes the Fed raising interest rates and also higher inflation in general." Goldman Sachs said on Thursday that it has raised its forecasts on U.S. Treasury yields for this year, citing more broad-based and persistent price pressures and a more hawkish pivot by the Federal Reserve.
It is not possible to know which expectations are correct until after they have occurred and the actual results have emerged, but we can study the past to see how the stock markets performed in the first year in which the Fed began its tightening policy as the chart below shows.
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