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Enough is enough! The economy has demonstrated an astonishing amount of resiliency against the headwinds thrown at it over the past two years—Covid-19, both short and long, surging energy prices, spiraling interest rates, supply shortages and, not least, stubbornly high inflation. Through it all, the job market has remained hot, consumers have kept their wallets open and the broader economy has stayed afloat, notwithstanding two misleading quarterly declines in GDP. But the party’s uninvited guests are getting too intrusive, and policymakers are taking away the proverbial punch bowl. They thought the festivities could continue at a quieter decibel if the less-welcomed guests left the party. They have not, and that benign approach is now being discarded in favor of some tough love.
As summer draws to a close, the debate over whether the economy is overheated or rapidly cooling remains unanswered. According to the broadest measure of activity, conditions look downright recessionary, as GDP contracted for the second consecutive quarter in the April-June period, satisfying the common yardstick of a recession. But the economy’s fundamental underpinnings depict anything but a downturn. The labor market is hot, churning out more than a half-million jobs in July and driving the unemployment rate to a 50-year low of 3.5 percent. Unsurprisingly, the tight job market is spurring robust wage increases.
The recession talk has ramped up considerably this week amid Fed Chair Powell's not-so-veiled acceptance that it's a price he's willing to pay to curb inflation. Investors are clearly taking heed, sending stock prices plummeting following the Fed's latest outsized rate hike this week and driving yields up to levels not seen since 2008, an acknowledgement that the Fed will follow through with more hikes in coming months. Clearly, Powell is striving to keep inflationary expectations in check as an integral part of his anti-inflation fight. But the self-fulfilling nature of expectations can feed into the economy as well as inflation. If the public worries over a recession deepen, it can cause behavioral changes that increase the odds of it happening.
The plunge in stock prices following this week’s consumer price report starkly reveals what can happen when events fall short of expectations, even if the miss is relatively minor. The unsightly 178 point decline in the S&P 500 on Tuesday, the day of the CPI release, was the steepest for a single day since the pandemic-induced shock in March 2020, when the economy looked considerably bleaker than now and inflation was not on the radar screen of investors. But inflation is now the primary scourge of the economy, and the uncertainty it is generating regarding future profits, jobs and the overall health of the economy is just as intense as it was during the onset of Covid 19.
Following a slew of speeches and public comments by Fed officials, highlighted by Chair Powell’s appearance at the Cato Institute’s monetary policy conference on Thursday, the Fed now enters its traditional quiet period until the September 20-21 policy meeting. But by all accounts, the meeting will be anticlimactic, as the message conveyed by the Fed speakers this week strongly suggests that the FOMC will deliver another outsized 0.75 percentage point interest rate increase. The economy, despite evidence that inflation and inflationary expectations have peaked, is softening and recession fears are permeating corporate boardrooms and the mindset of households.
It’s more than likely that the economy is not in a recession, despite two consecutive quarterly contractions in GDP. But while the economy’s growth engine is still powering forward, it is hardly running on all cylinders. The main driver, consumer spending, is providing much-needed fuel to keep the engine running, as evidenced by this week’s retail report for July. But households are facing formidable headwinds as increasing borrowing costs and torrid inflation are squeezing budgets, even as the main offset to shrinking purchasing power – income-generating job growth – is poised to slow.
After suffering through a yearlong battering of unrelenting bad news, inflation doves finally had a week to celebrate. For sure, it's still unclear if we are seeing the beginning of the end of accelerating inflation, or the beginning of false positive readings that obscure the true inflation trend. That unanswered question looms large and the fog of uncertainty won't clear up for at least several more months. Nor does it move the needle on the policy front, which remains steadfast in the inflation fight and instills concerns about a mishap. That said, baby steps should be rewarded, and the financial markets are eagerly embracing the positive signals that shone brightly over the past week.