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Inflation, the Fed, and Recession. It's Not Linear.

Updated: Jul 25, 2022

Will the Fed increase rates more, and are we in or headed for a recession? Several factors play a part in addition to rates.

The June CPI number came in at 9.1%. This is not only the second consecutive month that we’ve seen an increase – it was a whopper. Consensus expectations were for an 8.8% annualized increase in inflation. This huge spike came after the Federal Reserve raised interest rates by a surprise 75 basis points after the June meeting and communicated that more – and higher – rate increases are in store.

As measured by the futures markets, the immediate response was to assume that the high inflation number would increase the likelihood of the Fed enacting at least a 75-basis point rate increase and potentially a 100-basis point increase at the FOMC meeting at the end of July.

The Fed raising rates so quickly, and by so much, will not only cause havoc in the bond and the equity markets. It will increase the widespread assumption of many market participants, economists, and pretty much everyone else that if we aren't already in a recession, we will be at some point in the near future.

Both inflation and recessions are susceptible to sentiment. Specifically, when consumers think inflation will increase, it very often does. Fed Chairman Powell alluded to this relationship in his comments after the FOMC meeting last month, and the notes to the meeting made it clearer. The Fed didn't just look at the inflation number (the Fed prefers PCE inflation to CPI, but PCE went up as well). It also looked at the University of Michigan Consumer Expectations data on inflation, which showed an increase.

Recession expectations work the same way. It becomes apparent first in the equity and bond markets, which price into assets today where the markets expect prices to be in the future. This is why equity markets tend to decline before a recession. When consumers and corporations begin to fear recession and then make substantive changes to spending behavior, the retrenchment has ripple effects across the economy and leads to more economic cooling than would be indicated by the monetary policy moves the Fed is making.

This is the problem with the Fed using past-tense data to fix a future-tense problem. The Fed's moves to slow the economy have an impact beyond tightening the availability of money. It's challenging to know when and how much to raise rates because factoring in the future behavior of all the actors is impossible.

The challenge for the Fed is to decrease money available for investment for corporations and consumers and communicate its serious intentions to continue doing this until it hurts. But not so much that everyone loses hope and refuses to participate. Kind of like some aspects of parenting. Or training a cocker spaniel.

So Will the Fed Increase More, and Are We Headed for (or in) A Recession?

A famous Sherlock Holmes quote is, "Data, data, data! I can't make bricks without clay!" What is the Fed's clay?

The strength of the labor markets. Fed Chairman Powell has called the labor market "unsustainably hot." This is both underpinning the economy and a rationale for raising rates. The Fed has indicated that a continued strong labor market may mean that aggressive rate increases will not increase the risk of recession. The U.S. Bureau of Labor Statistics reported total nonfarm payroll employment rose by 372,000 in June, and the unemployment rate remained at 3.6 percent.

Consumer spending. Money talks, right? Well, consumers are still gabbing away. Retail sales rebounded in June, increasing 1%, as reported by the Commerce Department. Even accounting for spending on gas and cars, which are seeing huge price increases, retail sales rose 0.7%

Consumer Sentiment. Michigan football may no longer capture attention, but the University of Michigan Consumer Sentiment Index sure is. The preliminary reading for July ticked up slightly off the historical low point of 50 that it hit in June.

Gross Domestic Product. We won’t have an official estimate of GDP until the end of the month, but the Atlanta Fed has created a model of GDP that attempts to forecast the key economic indicator, removing the lag of the official measure from the Bureau of Economic Analysis. The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2022 is -1.2 percent as of July 8th.

The Bottom Line

Are we in a recession? The National Bureau of Business Economics (NBER) is the accepted authority on a recession. The standard definition of a recession is two consecutive quarters of a contraction in the economy. If the official estimate of GDP comes in negative, the economy would fit that description. But those aren't the only factors NBER uses to determine when a recession starts.

The Fed will likely increase rates by 75 basis points in July, but given the positive data on consumer spending and sentiment, it may feel that a 100-basis point increase would do more harm than good.

For investors, whether we technically enter a recession or not may be beside the point. The shortest recession on record was in 2020 and lasted two months at the beginning of the pandemic. Even if the economy is headed into a recession, given the other positives, it may not be deep or longstanding.

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The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.

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Basepoint Wealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.


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