The Fed could push the US economy into recession

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Inflation rates for December showed no signs of slowing down, with (CPI) rising 7% year-on-year, while (PPI) jumped 9.7%. The big jump in the CPI and PPI is a surprise, especially after a weaker than expected December report and index and a sharp fall in gasoline prices in November.

Historically, trends have favored some easing of inflationary pressures based on these factors, but now, with oil returning to the upside and other commodities like those starting to rise again as some weaken. The significant risk to this economy is that inflation continues to rise, eventually dragging the US economy into a recession.

High inflation rates

Although high rates of inflation do not always lead to a recession here in the United States, since the late 1940s almost every significant spike in the consumer price index on an annual basis has been associated with a major US recession. While this time around may be different, the odds seem to suggest that it won’t.

Annual CPI change

Annual CPI change

Monetary policy tightening

While the Fed is now working hard to bring inflation rates down, it may be too little too late. The Fed is trying to tighten monetary policy, which is killing the demand side of the economy, when the US economy is already expected to see its growth rate slow. A recent Reuters poll shows growth in 2022 is expected to slow to 3.9% from an estimated growth rate of 5.6%, then slow further in 2023 to 2.5%. It wouldn’t take much for the Fed to overtighten and cause a contraction.

Annual CPI change

Annual CPI change

This is precisely what happened before. Historically, higher inflation has led the Fed to aggressively raise the fed funds rate in previous cycles starting in the 1970s. In each case, the combination of the higher fed funds rate and a he high inflation led the US economy to fall into recession. This time it looks like it will play out the same way as the Fed is now looking to raise rates in 2022 and markets are starting to price in up to four rate hikes.

Wages are not keeping pace

Real wages are another area of ​​concern. Recent data shows that when adjusted for inflation, wages fell 2.3% in December compared to a year ago, indicating that consumer incomes are not keeping up with the evolution of the dynamics of inflation in the economy. These salaries have been declining when adjusted for inflation since May 2021.

Modification of adjusted salaries

Despite all this high inflation and the threat of the Fed raising rates and shrinking the balance sheet, yields are not rising, especially on the long end of the curve. The is still trading around 1.75%. On top of that, the note is still only trading for 90 basis points. This leads to a flattening of the curve and suggests that the bond market is still having trouble believing that the Fed will be as aggressive in raising rates as the Fed implies.

It could only mean that the bond market doesn’t think the Fed will be able to raise rates as much as it claims because the bond market sees a major economic downturn coming. While the yield curve is yet to show any recession warnings, the spread between the and the is now trading at just 55 basis points and has flattened considerably since May. Currently, a reversal does not seem out of the question.

That would weigh on equity markets, with stocks at high valuations that don’t fully price in the chances of an aggressive Fed and are pricing in 8% earnings growth over the next 12 months. But if wages don’t keep up with rising inflation, it could put pressure on corporate earnings, slow growth and trigger multiple contractions, driving stock values ​​down further.

It looks like history is about to repeat itself, yet again.

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