The US economy has struggled through a bout of high inflation, with employment remaining strong over the past year despite inflation rising to a 40-year high. Now the markets are signaling that the mess is ending and something worse is taking its place.
The Federal Reserve, the BFF of the markets for much of the last decade, is now more like an enemy. On September 21, the Fed raised interest rates by three-quarters of a percentage point, as expected. It also signaled more aggressive rate hikes ahead.
This is the stubborn Fed that may need to wreak economic havoc to prevent worse damage that would come from runaway inflation.
“The chances of a soft landing are likely to diminish to the extent that policies have to be more restrictive or longer restrictive,” Federal Reserve Chairman Jerome Powell said Sept. 21.
Here’s what he means: With inflation still uncomfortably high, the Fed needs to keep raising rates. That increases the likelihood of a recession, including the likelihood that more people will lose their jobs and suffer the ravages of unemployment.
It hasn’t happened yet.
Federal Reserve Board Chairman Jerome Powell holds a news conference Portal/Kevin Lamarque
Inflation peaked at 9% in June and then fell to 8.2%. At 3.7%, the unemployment rate remains close to an economic low.
But inflation isn’t falling fast enough for the Fed, which has raised short-term rates from around 0% to around 3%. Longer-term interest rates on consumer and corporate loans rose by similar margins. When interest rates rise and borrowing becomes more expensive, spending and hiring typically slow. Weaker demand reduces pressure on prices and lowers inflation.
A soft landing would be a steady decline in inflation that doesn’t disrupt jobs or depress economic growth too much. The stock market rallied in July-August as falling oil and gasoline prices and a few other factors suggested inflation would ease without drastic action from the Fed. Investors count on a soft landing.
But August inflation came out surprisingly hot, sending the Fed into shock-and-awe mode. “Fed on warpath,” Bank of America warned clients Sept. 23. “Probably overshooting and hard landing. Central banks will rise until something breaks.”
The story goes on
Like other forecasters, BofA lowered its outlook for the economy on inflation news and the Fed’s move to even tighter monetary policy. The bank now expects a recession in the first half of 2023, with unemployment rising from 3.7% to 5.6% by the end of next year.
A rental sign is posted on the door of a GameStop in New York City, the United States, April 29, 2022. Portal/Shannon Stapleton
“The Fed’s actions tell us that it is committed to reducing inflation and appears willing to accept some deterioration in labor market conditions,” BofA researchers wrote. “We believe our guidance is consistent with the Fed taking ‘serious action’ to rein in demand and choosing to do more rather than less.”
[Follow Rick Newman on Twitter, sign up for his newsletter or sound off.]
Other recession indicators start blinking.
The spread between 10-year Treasury yields and 2-year Treasury yields – known as the yield curve – has been negative since July, meaning that short-term rates are higher than longer-term ones. An inverted yield curve, as it’s known, is a condition that typically occurs before a recession, with very few false positives.
Moody’s Analytics points out that a measure of change in unemployment, known as the Sahm rule, could also point to an impending recession. If unemployment rises as the Federal Reserve’s latest forecast suggests, the pace of deterioration would reach a threshold typically associated with a recession by May next year. Moody’s Analytics believes the US economy will narrowly avoid a downturn, but also says that “a soft landing…is an increasingly tenuous prospect.”
Traders work on the trading floor of the New York Stock Exchange (NYSE) in Manhattan, New York City, U.S. September 13, 2022. Portal/Andrew Kelly
Markets have certainly turned gloomy. Stocks have plummeted over the last month, with the S&P 500 stock index down a painful 13% since mid-August. On September 23, it hit its lowest level since late 2020, when the economy was still Covid-locked and vaccines were not yet available. Oil prices fell below $80 a barrel despite tight supplies, signaling recession worries not just in the US but around the world.
The political implications probably depend on the timing of the hard landing.
Consumer confidence has actually improved from the dismal level of early summer. That’s because of the huge drop in gas prices, which seems to be hurting confidence more than anything else. President Biden’s approval rating rose as gas prices fell.
Biden seems to understand the correlation between gas prices and the president’s popularity. Its plan to release 1 million barrels a day of oil from the national reserve was due to end in October, but the Department of Energy recently said it will release another 10 million barrels a day in November.
To enable screen reader support, press ⌘+Option+Z. To learn more about keyboard shortcuts, press ⌘Slash
It must be a coincidence that the midterm elections will take place on November 8th.
The market sell-off appears to be a downside re-rating of assets in anticipation of a recession that may not materialize for several months. The Fed could hike rates by another notch or more by the end of the year, then pause and see what happens.
If there is a hard landing and a recession hits, that should put a brake on inflation, although unemployment would worsen. Some economists believe the Fed will cut rates again by the end of 2023 to combat the recession it could eventually cause. Whether the landing is soft or hard, you need to get back in the air.
Rick Newman is a columnist for Yahoo Finance. Follow him on Twitter at @rickjnewman
Click here for political news related to economy and money
Read the latest financial and business news from Yahoo Finance
Download the Yahoo Finance app for Apple or Android
Follow Yahoo Finance on TwitterFacebook, Instagram, Flipboard, LinkedIn and YouTube