A Hard Landing for the Economy Is Looking More Likely

Highlights Sep.26,2022 14:50

Forget transitory. Forget the soft landing.

Reality is setting in that the markets and the economy will not get out of the Federal Reserve’s aggressive battle against inflation without a recession. About the only question now is how bad it gets.

Even Fed Chairman Jerome Powell seemed to concede the point last week after announcing the central bank’s third consecutive 75 basis point hike in interest rates, the medicine it has prescribed for the rampant inflation.

Wall St drops to two-month lows as recession fears mount

“No one knows whether this process will lead to a recession or, if so, how significant that recession would be,” Powell told reporters following the announcement. “That’s going to depend on how quickly wage and price inflation pressures come down, whether expectations remain anchored and also if we get more labor supply.”

Markets have already made up their mind on how this movie ends.

Following Friday's 486-point selloff, the Dow Jones Industrial Average ended the week at its lowest point since 2020, as the pandemic shut down the economy.

Bond yields rose, meanwhile, sending Treasuries to 11-year highs with the 10-year near 3.7% and the 2-year yield above 4.1%. The fact investors are asking for more on the shorter duration bond says they think the economy faces greater risk in the short term than the future.

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Wells Fargo Corporate and Investment Bank Econometrician Azhar Iqbal and Economic Analyst Nicole Cervi wrote on Friday that “a recession in the next year is more likely than not, in our view.”

“We do not believe the U.S. economy is in a recession at present,” they added. “Our forecast calls for a recession starting in Q1-2023 with three consecutive quarters of negative real GDP growth and output growth turning positive in Q4-2023.”

The Fed is hoping that raising interest rates will cool economic demand enough to dampen the still-strong labor market and its recent projections see the unemployment rate reaching 3.9% in 2023 and 4.1 in 2024 from its current 3.7%. But no one really knows what level of job losses it will take to arrest wage inflation at a time when the labor force is facing significant demographic changes.

One area of the economy that is already seeing the effects of the Fed’s moves is housing. As mortgage rates have reached levels that are double what they were a year ago, and are now down about 20% from a year ago. Prices, meanwhile, are no longer rising at the pace they were in 2021.

It’s quite a turnaround for the Fed and the Biden White House, which held on to the idea of inflation as “transitory” throughout most of 2021 even as consumer prices began their ascent to levels not seen since the 1980s. Massive fiscal and monetary stimulus engineered by Congress and the Fed juiced the economy, and then the Russian invasion of Ukraine in February of this year drove energy prices and overall inflation upward.

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Until recently, the markets seemed skeptical that the Fed really meant it in terms of squeezing the economy hard enough to break inflation, forcing Powell to hammer the point home in August at the Fed’s summer symposium in Jackson Hole, Wyoming.

“Today, my remarks will be shorter, my focus narrower, and my message more direct,” Powell said, while not taking any questions. “Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.”

The markets sold off after Powell spoke, but then recovered somewhat as traders still believed the Fed would perhaps ease back in early 2023.

Last week, the markets threw in the towel with the Fed’s September meeting ending with the third consecutive 75 basis point hike in interest rates. The Fed did more than just raise interest rates. It provided an update to its economic forecast and sharply reduced the outlook for the near term.

Growth in the nation’s gross domestic product was revised downward for 2022, falling from 1.7% as recently as June to 0.2% now. Forecasts for 2023 were trimmed and the Fed now says the economy will operate below “trend growth” until 2025.

“The impression one gets from the (revised forecasts) and Powell’s remarks is that the “(Fed) is in for a very challenging few years and is operating in uncharted waters,” Robert Eisenbeis, vice chairman & chief monetary economist at Cumberland Advisors, wrote last week.

On Sunday, in Atlanta Fed President Raphael Bostic sounded a positive note, saying: “I do think that we’re going to do all that we can at the Federal Reserve to avoid deep, deep pain.”

The government will release updated inflation data for August on Friday from the personal consumption expenditure price index, a measure that is closely followed by the Fed. Forecasts are for the PCE to show a drop to a 6% annual rate from its current 6.3%, although there is a chance the month-over-month data will post a small increase.

It’s not just the U.S. that is feeling the pain. Europe is facing high inflation, an energy crisis from its dependence on Russian gas, and weakened currencies from a dollar that has rallied as the rest of the world suffers. In the U.K., where the Bank of England has already declared a recession is underway, new Prime Minister Liz Truss’ proposed tax cuts were met with a drop in the markets and the pound’s value.