Markets See Recession – But Not The Fed
We have opined several times that we think the Fed has backed itself into a corner with its 'transparency' regime. We are now at the obvious point where Recession has set in, and inflation has…
The CPI for November (+0.1% M/M) was milder than markets expected, which brought the Y/Y CPI inflation rate to 7.1% in November from 7.7% in October. The core CPI (ex-food and energy) rose +0.2% M/M, the smallest increase since August 2021. Excluding shelter, the Core fell -0.1% for the second month in a row, an extremely rare event. Durable goods prices fell by a large -0.9% in November after falls of -0.7% in October and -0.1% in September (now, that's deflation!). The Y/Y rise in the Core was 6.0% in November from 6.3% in August. With gasoline prices declining in December, the next headline CPI M/M is likely to be negative! The index was impacted by a rise of +0.7% in OER (Owners' Equivalent Rent) and +0.8% in rents. As we've commented in past blogs, the methodology used by BLS for shelter costs lags reality by several months. Had current trends in shelter costs been used, headline CPI would have been negative in November, as CPI less food, energy and shelter costs fell -0.1%. Those prices fell -0.4% in October and were flat (0%) in September. That is the weakest three-month period since March-May 2020, the initial months of the Covid lockdowns. Given the emerging weakness in the economy, we see a continuation of disinflation over the next few months, turning to outright deflation when BLS's methodology recognizes the downtrend in rents; that should begin in Q2 2023.
We did a thought experiment looking at Y/Y CPI (which is what the Fed is looking at) using different changes in the monthly index. The table shows the Y/Y rates of CPI inflation at constant M/M changes.
Y/Y CPI at Constant M/M ChangesUniversal Value Advisors If a M/M growth in CPI of +0.1% is repeated every month, the table shows that the Fed's 2% inflation goal is attained next June (+1.7%). If, as we think, we will be seeing negative monthly CPI readings, that 2% Y/Y goal will be achieved early in Q2 next year depending on the severity of the deflation metric. The incoming data suggest zero or negative near-term M/M readings, especially as the rents segment of the CPI recognizes the downtrend there. Remember, it wasn't that long ago when the Fed couldn't get inflation up to its 2% goal. We think that scenario will begin again late in 2023 or in 2024. In 2021 the markets were fixated on the acronym T.I.N.A. (There Is No Alternative). This was popular in 2021 when stocks were moving up and the Fed had interest rates pegged near zero. Stocks were the only alternative! In a recent writing, Michael Lebowitz coined a new acronym – BAAA (Bonds Are An Alternative), as even short-term T-bills pay a decent rate of return. Recessions always bring bond yields down (and their prices up). In fact, long-term bond yields peaked in October (the 10-Yr Treasury was 4.225% on October 19 and closed Friday (December 16) at 3.488%, a fall of nearly ¾ of a percentage point.
It should be noted here that inflation is a process, a rate of change. Prices have climbed significantly (by 14.4%) over the past two years. Simply having a 0% rate of inflation doesn't lower prices – it just maintains therm. So, some period of deflation, if we could have that without huge employment losses, would be welcome. Unfortunately, employment losses usually accompany a deflationary scenario. And, of course, employment losses are the primary element of a Recession.
The Fed Raises 50 Basis Points
On Wednesday, the Fed raised rates by 50 basis points (bps) as expected. The Federal Funds rate is now 4.25% to 4.50%. The new Summary of Economic Projections (SEP), commonly known as the 'dot-plot,' showed a median terminal rate projection of 5.1% for 2023, up from 4.6% in their last (September) projection. This means the Fed intends to raise rates another 85 bps in 2023.Implied Fed Funds Target RateFOMC
Given falling inflation expectations and a view that the economy is headed for Recession, the financial markets see rate cuts in 2023, and, as indicated above, over the past few weeks, market interest rates have been declining. This is an issue for the Fed, as they don't want markets to ease financial conditions. As a result, the dot-plot and the accompanying rhetoric in the post-meeting press conference had to be hawkish. This is a consequence of this cycle's Fed 'transparency,' where Fed future intentions are communicated to the markets and markets immediately move financial conditions to where the Fed says they intend to go. That worked well when inflation was rising, and the economy was strong. But now inflation is falling, the economy is weak, and markets know that sometime next year, the Fed will have to ease, especially if the Recession is deep. Note in the chart that 17 of the 19 dots (yellow dots in the chart for 2023) are above 5% (5.125% median), with the other two just under that rate. Note that two dots are at 5.625% (very top of the chart), and one of them stays there through 2025! At the press conference, Powell was quite hawkish indicating that there is no sentiment on the FOMC to cut rates in 2023.
We suspect the 2023 dots were orchestrated to show a high consensus level, especially since there appears to be no consensus at all within the FOMC regarding rates in 2024 and 2025. Note the wide dispersion of sentiment among FOMC members with the dots ranging from 3.1% to 5.625% in 2024 and 2.4% to 5.625% in 2025.
Again, the required 'hawkish' position of the Fed is a consequence of their new 'transparency' in this tightening cycle. They can't let markets ease financial conditions when they still don't believe they have conquered the inflation beast.
The word 'believe' is important here. It appears that the Fed is wed to the Y/Y rate of inflation, i.e., that 7.1% Y/Y reading. At the press conference, Powell, speaking about inflation, said '…it's good to see progress, but let's just understand we have a long ways (sic) to go to get back to price stability.' Since the Fed's goal is 2% inflation, then that is probably the Fed's 'price stability' definition. Looking at the CPI since June, i.e., over the past 5 months (July to November), the annualized rate of growth (i.e., inflation) of the CPI is 2.45%. That's almost at the Fed's target, and we think we will see negative CPI growth in the months ahead. Nevertheless, by looking backward at the Y/Y rate, this Fed is missing the downturn in inflation. As we have said in past blogs, like driving while looking through the rear-view mirror, you know where you've been, just not where you're going!
In the end, markets knew exactly what the Fed was up to and aren't buying their hawkish front. In fact, on Wednesday, December 14, markets moved yields lower on the day. And for good reason: during the press conference, Powell did say that it is appropriate for the Fed to continue to 'step-down' rate increases and let the restrictive policy the Fed has engineered to date continue to impact the economy. This implies a 25-bps rate increase at the Fed's next meeting (January 31-February 1).
The Fed also lowered its GDP projection for 2023 to +0.5% from 1.2% in their September projections and raised the expected unemployment rate in 2023 to 4.6% from 4.4%. Note that there has never been a time when the unemployment rate rose more than 1 percentage point from the cycle low (3.5%) without a Recession ensuing. Of course, they know they are causing a Recession; politically, they just can't say so!
Retail sales cratered -0.6% in November. The Wall Street consensus was for a fall of -0.3%, so a big miss. On a Y/Y basis, retail sales are up +6.5%, but inflation is up +7.1%, so, on a real (volume) basis, sales have fallen. Some of the categories showed large negative readings M/M: auto sales were off -2.3% and down in two of the last three months, furniture/home furnishings fell -2.6%, and building materials sank -2.5% (not unexpected given the housing scene).Johnson Redbook Same Store Sales & Gasoline PricesUniversal Value Advisors
Sales of electronics fell -1.5% and have fallen for seven months in a row, the largest losing streak in the data back to its 1992 inception. Gasoline sales even fell -0.1% (falling prices). Of importance, online sales, one of the growth areas in retail, were down by -0.9%. And Johnson Redbook same store sales for November cratered -2.9%.
Recent surveys by the NY and Philadelphia Regional Federal Reserve Banks also painted a downbeat picture. The NY Fed survey came in at -11.2 for December vs. +4.5 for November. This number measures the difference between companies who say they are expanding vs. those that say they are contracting. That means that 44.4% of those surveyed said 'expanding,' while 55.6% indicated contraction. This was the fourth negative reading in the past five months.
At the Philly Fed, the survey number was -13.8. This survey averages +13.6 during business expansions. This was the fourth month in a row of contraction, the longest negative streak in nearly seven years. And the workweek shrank (-8.9 points), and employment intentions also contracted (-1.8). There were negative readings on new orders, unfilled orders, delivery times and prices paid and received. This certainly looks promising for the inflation picture. Unfortunately, not so good for the economy. And the ISM Manufacturing PMI also slipped below the magic 50 mark into contractionary territory at 49.0 from 50.2 in October. The peak was 63.7 in March 2021.
The chart below shows the tight relationship (4-month lag) between the Supplier Delivery Index and Core CPI goods. Since the supply chain is back to normal, we should continue to see goods prices deflate.CPI Core Goods Inflation & Supplier Delivery Delay IndexRefinitiv, Capital Economics
Industrial Production fell -0.2% in November. The fall would have been much larger except for the large rise in utility output (+3.6%) due to unseasonably cold weather. Manufacturing output was down quite a large -0.6% (consensus was +0.2%) and mining cratered -0.7%. Now that the supply chain is nearly back to normal and auto manufacturers have been able to get chips for the past few months, it appears that pent-up demand has been exhausted (as seen from the falloff in new car sales of -2.3%). Motor vehicle output fell -2.8% in November. Output in other vital sectors, like primary metals, computers & electronics, furniture, and textiles also fell. Given the NY and Philly Fed surveys discussed earlier, Industrial Production is likely to continue to fall again in December. Welcome to the Recession.
We have never seen a cycle in which the Fed continued to tighten policy in the face of strong incoming evidence that the Recession has already begun, and inflation is on the wane. Capital Economics Chief North American Economist, Paul Ashworth, titled his comments on the recent CPI report 'Stick a fork in it, inflation is done.'
The markets do recognize that the Fed is pushing the economy into Recession, as the equity markets have tanked since the Fed meeting and press conference. The DJIA tumbled -1,188 points (3.5%) from its Tuesday closing level (S&P 500 -4.2%, and Nasdaq -4.9%), as the Fed's hawkishness appeared unwarranted.
We have opined several times in this blog that we think the Fed has backed itself into a corner with its 'transparency' regime. We are now at the obvious point where Recession has set in, and inflation has succumbed. But, under this 'transparency' regime, the Fed can't admit to any of this, lest markets ease financial conditions earlier than the Fed desires. Thus, their hawkishness and the orchestrated 2023 dots in the Summary of Economic Projections (dot-plot).
We are concerned that this Fed is fixated on the Y/Y inflation metrics instead of on the recent emerging inflation and weak incoming economic data. It is our view that inflation will continue to fade and that by late Q1 the Fed will 'pause' (no more rate hikes) and then 'pivot' by late Q2 or early Q3. Unfortunately, that will be too late to prevent a long and deep Recession, not only because of what we consider excessive rate hikes, but also because this Fed is also orchestrating a rapid fall in the money supply, always a cause of negative economic growth.
(Joshua Barone contributed to this blog)