LAWRIE WILLIAMS: Downwards start to July. Is recession ahead?
The old adage – ‘Sell in May and go away’ – certainly looked to have been sound advice as July trading in almost all markets opened in Europe. Precious metals, base metals, equities and bitcoin were all, looking weaker as markets were bracing themselves for more inflation and a possible move into recession. Even a brief rally from a 0.1% fall in yesterday’s PCE inflation reading was insufficient to stem the tide on realisation that 0.1% was not really a significant figure in the face of an ongoing European war which was continuing to distort geo-economic figures and showed little sign of coming to an end.
Gold even fell back below the key $1,800 level and silver below $20 and bitcoin at one time dipped back below $1,900 again while the major stock indexes all showed continuing signs of weakness. The U.S. dollar Index eased up a little which was not a helpful sign indicating weakness elsewhere in the world.
June had already provided some surprises to the U.S. Federal Reserve and to many analysts who had assumed that May’s 50 basis point rise in the Federal Funds interest rate might at least to start to slow down inflation, although not yet to defeat it. In the event the May Consumer Price Index (CPI) showed an 8.6% year-on-year increase, around 0.3% above the consensus. 0.3% may not seem that significant a rise, but in economic terms it is a mountain and torpedoed a perhaps over-complacent Fed from its predicted path of the imposition of another 50 basis point interest rate rise at the mid-June FOMC meeting, which followed the CPI data announcement by just a few short days.
The markets had already previously been extremely nervous about the further predicted 50 basis point rise in interest rates, and now there was the prospect of an even more aggressive Fed interest rate raising programme. Almost immediately the higher than expected CPI figure came out, market consensus had moved from the anticipation of the 50 basis point interest rate rise to one of 75 basis points or even higher, confirmed by subsequent Fed action.
In his post-meeting statement, Fed chair Jerome Powell did seemingly try to lower expectations of further similarly sized interest rate rises, and the prospective damage this could do for any economic recovery. After a brief correction, though, market over-confidence appeared to come to the fore with several days of equity market index growth and a stuttering gold price. For example the major U.S. stock indexes al index moved up quite strongly and even bitcoin made something of a recovery from its low point. However this all proved to be a false dawn with the Dow falling back to 30,775, the NASDAQ to just over 11,000 and the S&P to 3,785 at the end-May close after all had traded lower during the day. It will be interesting to see what happens to them today.
The 75 basis point rate increase at the June FOMC meeting was the highest since 1994 putting the current range at 1.5%-1.7% which suggests a year-end range of at least 3.25%-3.5% and probably rising 4% or higher in 2023. In relation to current inflation levels these rates are still ultra-low and many analysts fear that if the inflation rate at the next couple of CPI data announcements does not start showing a substantial decrease, even a repeat of the 75 basis point level of rate increases will be insufficient to stem the inflationary tide.
In short, the U.S. economy may already be in a period of stagflation brought on by high energy prices and static, or potentially falling, employment growth. Indeed it is straying perilously close to a technical recession – defined as two successive quarters of declining growth. Whether it can pull out of this particular abyss remains to be seen.
Powell, in his latest testimony to the Senate Banking Committee, seems to discount the likelihood of an imminent recession given his confidence in the strength of the U.S. economy (not shared by all). But the Fed does not have a strong track record on its short term economic forecasting.
Powell also commented in his Senate testimony: “My colleagues and I are acutely aware that high inflation imposes significant hardship. Over coming months, we will be looking for compelling evidence that inflation is moving down, consistent with inflation returning to 2%. We anticipate that ongoing rate increases will be appropriate; the pace of those changes will continue to depend on the incoming data and the evolving outlook for the economy."
To bring inflation back to 2% is a somewhat optimistic target given the current economic pressures, exacerbated by the Russia/Ukraine war and the effects of the supply chain issues resulting from the Covid-related lockdowns in China. Problems in so doing thus persist and one suspects inflation levels could well get worse before they begin to get better with the key inflation drivers – energy and food prices – largely outside the Fed’s control.
The 75 basis point rate increase at the June FOMC meeting is a reflection of the Fed’s current more aggressive approach. Powell feels that the currently strong labour market could well be unsustainable too in the light of current trends and admits that the Fed is indeed a massive way off its target inflation levels. The high June CPI figure came as a surprise, albeit perhaps a predictable one, and he admitted that further such surprises could be in store, with the Fed adjusting its rate policy accordingly.
While he has tried to play down the likelihood of another 75 basis point increase at the next FOMC meeting in late July, if inflation remains elevated, as we think it may well be, another similarly aggressive rate increase cannot be ruled out. If that happens it could lead to a substantial blow to the equities markets which have become used to low interest rates and Fed largesse for their growth. It could thus well be sufficient to drive the US economy into a late-year recession unless the Fed reverses course again. If the latter we are almost certainly going to be stuck with high inflation for the foreseeable future.
Inflation or recession – which is the worse of the two evils? That is the dilemma in which the Fed will likely find itself. The decision to raise rates by 75 basis points in June reflects that thinking. "We thought it was appropriate to move more aggressively," Powell said. "Right now, the labor market is unsustainably hot. On the inflation side, we are far from our target. We have to restore price stability in order to have a sustained period of maximum employment in the longer term."
Powell also did not rule out more surprises when it comes to inflation, stating that the economy often evolves in unexpected ways. "Inflation has obviously surprised to the upside over the past year, and further surprises could be in store," he said.
In terms of recession risks, Powell reiterated that the American economy is "very strong" and is well-positioned to handle tighter monetary policy. He added that the likelihood of a recession is "not particularly elevated right now." He has been wrong in the past so don’t be too surprised if he is wrong again!