Inflation Leaves The Fed With A Smaller Window To Avoid Recession
Share this

Stocks took it on the chin last week as the market repriced the odds that the Federal Reserve (Fed) can tame inflation and avoid a recession. May consumer inflation (CPI) hit a forty-year high at 8.6% year-over-year, while economists expected the level to hold steady at 8.3%. In addition, the level of “sticky” inflation, which will be more difficult to curb, rose to 5.2% year-over-year.

Lower-income families, in particular, feel the pinch from the increase in food and fuel prices, though, and are forced to forego spending on other items due to the price increases. Pressure continues to build on households as gasoline prices hit a new high above $5 per gallon last week.

In the wake of the hot inflation reading, markets quickly priced in an additional hike of 25 basis points (0.25%) over the next 18 months. The markets expect ten rate hikes of 25 basis points from the Fed over the next year and a half. Most rate increases are expected within the next few months as the Fed plays catch-up with rampant price pressures. Fed Fund futures are discounting at least a 50 basis point (0.50%) hike on Wednesday, July, and September. Investors will be on edge listening for a possible acceleration of the tightening in monetary policy to 75 basis point increments. The good news is that a very aggressive path of rate increases is already discounted by market participants, so this week is not destined to repeat the pain in the stock market that characterized last week’s trading.

Despite the inflationary challenges to the consumer, households have accumulated significant savings that can be used to supplement income to support consumption. It is challenging to forecast the timing of recessions, but the economy seems to have enough momentum and cushion to make the odds of recession fairly low until late 2022 at the earliest.

The National Bureau of Economic Research (NBER) is considered the “official” arbiter of declaring a recession, but its pronouncements typically occur after the economic downturn is already over. This fact causes analysts to look for more timely methods to forecast a recession. Fed studies have shown the near-term forward spread to be perhaps the best predictor of an eventual economic downturn and forward stock market returns. Currently, this indicator shows very little chance of a recession within the next two years. A simple real-time method to determine if the economy is perhaps already in a downturn is the Sahm Rule, which uses a rise in the unemployment rate as a signal. The Sahm Rule also shows no sign of a current recession.

Forecasters are less optimistic than the pure quantitative indicators about the possibility of the Fed achieving a soft landing with this tightening cycle. History would indicate low odds of the Federal Reserve avoiding recession once they begin to raise rates, even in the absence of an inflation problem. The need to battle high inflation would suggest a higher probability than usual that an economic downturn will result from this tightening cycle.

After being down 19% from the peak in mid-May, the S&P 500 is back close to those levels after the 5% decline last week. In the previous twelve recessions, stocks have typically declined by 24%, so the S&P 500 is nudging closer to pricing in an economic slowdown. Stocks almost always fall before a recession, but not every sharp stock decline is accompanied by an economic downturn.

A silver lining in the sell-off is that forward stock returns have historically been elevated after a bear market decline of at least 20% from the peak. While stocks can and probably will decline past a bear market level, the rebound is typically explosive and happens before the economy recovers.

Investors should always focus on an asset allocation that provides the financial means to persist through any volatility and economic downturn. Aside from holding some safe and liquid assets to cover living expenses during any economic and market turmoil, this downturn should be a long-term buying opportunity for those able to add to stock positions. Holding a safe reserve of living expenses, a dollar-cost averaging buy program, or mechanical rebalancing to an asset allocation target can help improve future returns and deal with the fears that investors face during these times. Within stocks, investors should focus on companies that can survive a likely recession and thrive once the storm passes. Given the inflationary threat, the company’s power to pass along price increases without collapsing demand for its products is critical.

Share this
You May Also Like

11 Ways to Brand Yourself as a Speaker

Opinions expressed by Entrepreneur contributors are their own. Whether you’re giving the…

Ivory Coast, a Big Cocoa Exporter, Tries to Move Up the Ladder

GRAND-BASSAM, Ivory Coast — The worker carefully peeled the husks from the…

Economic Recovery Gains Momentum In 2022

This story appears in the August 2022 issue of Forbes Asia. Subscribe…

OPEC Cuts Oil-Demand Forecasts as Economic Growth Slows

Global oil demand will be weaker than expected this year and next…

SpaceX Misses Out On $888.5 Million Government Subsidy For Starlink

Topline The Federal Communications Commission has denied SpaceX’s application to receive $888.5…

Bitcoin traders still favor new $20K lows as Ethereum hits $2K

Bitcoin (BTC) is still due to return to near $20,000, fresh analysis…

Fallout from crypto contagion subsides but no market reversal just yet

The blockchain industry showed some surprising resilience in July, which may point…

ASIC chair troubled by sheer amount of ‘risk-taking’ crypto investors

The chief of Australia’s financial services regulator Joe Longo has raised the…