Economic Commentary – Inflation, Recession & The Fed

The Fed’s move this week (6/13/22 – 6/15/22) to increase the Fed Funds rate by 0.75% was a surprise, and the market hates surprises and has dropped precipitously. Conventional wisdom holds that the interest rate hike and market drop point to a major recession. We do not believe this is the correct interpretation, and we want to offer a different perspective.  

What we’re seeing is the reaction to the surprise, not to poor economic fundamentals. The Fed took several days to signal that it was going to raise interest rates more than expected, and the market reacted to those signals over the same period.    

What made this startling in a sense is the contrast with Powell’s statements in May. At that time, he had been almost dismissive of any suggestion that rates might move up more than 0.50%. Everyone expected a 0.50% rate increase in June with a likely 0.50% increase in July. Monday through Wednesday of this week, Powell made it clear that the Fed was going to be more aggressive in fighting inflation than it had said it would be.  

We got a 0.75% rate increase (the largest since 1994) with an almost certain additional 0.75%increase coming in July. For all intents and purposes, that July move is now already priced into the stock market, and it should not further spook the market.

It’s good that the Fed is taking inflation seriously. Depending on how you measure it, inflation is running at 6% to 8% and is likely to remain in that range for a while. Preventing it from getting worse and then ultimately taming inflation is absolutely necessary. Whether taming it causes a recession is the question of the day. Conventional wisdom says that raising interest rates cause recessions. This is not correct, as the following chart illustrates.

The chart shows time periods when rates went up and a recession occurred. But the chart also shows time periods when rates went down and a recession occurred, as well as time periods when rates went up but no recession occurred. It is possible for rate increases to cause a recession, but these occur when the rate hike is excessive. It is not the fact that rates went up; it is the fact that rates increased too much at that time. It is a complicated relationship and needs to be understood as such. The “easy” media-provided answer is most often too simplistic.

Now, while an excessive interest rate increase can cause a recession, more often, the recession is caused by bad policy decisions out of Washington. When tax and regulatory burdens restrict businesses from producing, or weaken the profitability of producing, businesses will retrench; they cut back on production, stop hiring or lay off workers. Excessive interest rates can also make it unprofitable to produce, but again it is excessive interest rates, not just a rate increase, that could cause a recession.

As we’ve written before, we do not see signs of a recession. We won’t reiterate the list in detail, but when we consider various manufacturing indexes, new orders, payroll levels, demand for services, or personal income, we don’t see evidence of a recession. As things stand now, there is no reason corporate profits cannot be sustained or even increased, and that is the base level indicator of recession or expansion. Accordingly, we do not expect a recession.

On the other hand, we are not predicting wild, heady growth. But we do see a path forward for muted, sustained growth. Even the Fed is projecting 1.7% real GDP growth for 2022. That is anemic, but it is growth, not recession.

The broad stock market is currently in bear market territory, off 18% as of this writing. We believe this reflects fear and surprise, not an economic downturn. It is important to remember that the broad stock market is a discounted valuation of future expected corporate profits, along with some emotions (fear or exuberance) potentially thrown in. Both profit levels and interest rate levels combine to determine whether the market is over-valued, fairly valued, or under-valued. Here is our most realistic assessment of that interaction.

• With current corporate profit levels and the current 3.3% 10-Yr Treasury yield, the stock market is fairly valued.
• With current corporate profit levels and a 3.5% 10-Yr Treasury yield, the stock market would be slightly over-valued.
• With 10% higher corporate profit levels and a 3.5%10-Yr Treasury yield, the stock market would be slightly under-valued.
• With 10% higher corporate profit levels and a 3.75% 10-Yr Treasury yield, the stock market would be slightly over-valued.

Here’s the same assessment in table form.

We’ve thrown in an assumed increase in interest rates; it’s going to happen, and we want to be realistic in our assessment.

But we’ve also thrown in an assumed increase in profits, because we want to be realistic. Based on the evidence referenced above, and the still-recovering service sector, total corporate profits should grow roughly 10% this year. That could be interrupted, but there’s no inherent reason it has to be interrupted.

Where we sit right now is at a fairly valued stock market if profits remain as they are. But if profits go up as they should and rates go up to reasonable levels, we remain slightly under or slightly over-valued – basically neutral in one direction or the other. 

The danger is that profits will be repressed (bad policy decisions in Washington) and/or that interest rates are increased excessively.

What remains to be addressed in this explanation are the emotional and surprise factors. To the extent investors have confidence in the Fed’s ability to do its job, the market should reflect reasonable expectations of these profit and interest rate levels. When investors lose confidence in the Fed’s ability, they are more susceptible to worst-case predictions, and we then experience more severe swings in the stock market.  

The Fed’s move this week may well have been the right move to make. But the surprise of a 0.75% increase when 0.50% was expected has hurt the Fed’s credibility a bit. It isn’t gone for good, but the Fed needs to be careful now in how it sets and then meets expectations. Transparency and honesty in the Fed’s assessment of the inflation level are critical and will tell us a lot about the market’s future.

Ultimately, if the Fed raises rates in the right increments to the right level, there shouldn’t be a recession. If the Fed raises too quickly or just goes too high, we would expect a mild and short recession. No matter what the Fed does, if it communicates poorly, expect to see continued volatility in the markets even if the outcome at year-end is positive.  

Executive Summary

This week the Fed raised interest rates 0.75%, the largest increase since 1994. The markets reacted in a decisively downward direction. While conventional wisdom holds that the market dropped because the rate increase will cause a recession, we disagree. There is no recession on the horizon. The market dropped, reacting to the surprise factor and a certain amount of fear the Fed may not be on top of inflation. Ultimately, rates will rise more, the market can also rise, but the Fed absolutely needs to communicate better.