By Hani Redha, Portfolio Manager, Global Multi-Asset, PineBridge Investments
Investors looking for a barometer of the economy may be wise to watch the path of inflation over the next six months – which could largely set the direction and pace of growth for the next two years (or more).
US inflation surprised to the upside virtually across the board in June, further upping the pressure on the Federal Reserve as headline inflation reached 9.1% year-over-year, the highest level in 40 years, and the core measure (less food and energy) hit 5.9%. The Fed’s rapid rate hikes are now likely to continue unabated as it plays catchup, slowing growth or even, possibly, spurring a contraction. But their ability to bring inflation into an acceptable band remains to be seen, given some out-of-the-ordinary factors driving up prices on key contributors to the overall readings, including ongoing pandemic disruptions and the war in Ukraine.
As we watch the tug of war between inflation and economic growth play out, the path of inflation over the next six months will be pivotal to determining economic conditions over the next two years at least – primarily due to the long and variable lags between the resulting monetary policy actions and their ongoing impact on the economy. This means that even if inflation comes down after this six-month window, it may be too late, as the impact of policy will already be set into motion.
Consider three inflation scenarios – one benign, one a bit murkier, and one pretty dismal – and what they could mean looking out over a two-year horizon.
In the first, and most optimistic, scenario, the Fed’s signalling and hikes thus far paired with some favorable combination of loosening supply-side bottlenecks, better-than-expected crop yields, caps on Russian oil prices, and the like bring headline inflation under 4% by year-end. In this scenario, we would expect growth to plateau and perhaps tick up again over the next two years as the Fed and other central banks avoid overtightening financial conditions. But this outcome looks like a long shot from where we stand today.
The second scenario is what many of us at PineBridge expect to see: Inflation comes down to between 4% and 6% by year-end, creating a hazier outlook in which we might sidestep a recession with the right set of circumstances – small but meaningful surprises on food prices or rents, for example. Effectively, the descent of inflation over the next six months would be just enough to enable the Fed to avoid taking policy rates too deeply into restrictive territory and thereby causing a recession.
The third scenario is what consumers and investors are least hoping to see: Underlying pricing conditions don’t improve and inflation remains high, with US headline CPI staying above circa 6% by the end of 2022. In this scenario, avoiding a recession over the two-year horizon looks nearly impossible – the Fed will be bound to act aggressively, rising rates will further stall economic activity, and recession essentially becomes a foregone conclusion. This outcome is not our base case, but we certainly can’t rule it out. Again, it is crucial to recognize that even if inflation were to decline rapidly after this six-month window, the damage done by the lagged tightening of financial conditions that the Fed would have implemented may be irreversible, given the bluntness of policy tools.
So what will determine which scenario wins out in the end? The metrics we’re monitoring most closely include, of course, food and energy prices. While both were up dramatically in June, we’ve seen some good news more recently, with gasoline prices coming down quite quickly in July and wheat prices also dipping. This could bode well for July’s CPI numbers if the trends hold. That said, rents are also critical, and the recent surge in home prices is pushing rents higher, and with a long lag – so rents currently are moving in the wrong direction. Wages are another critical piece of the puzzle, and the most recent jobs report bore some good news, showing some cooling of wages.
Bottom line? While the latest CPI readings exceeded expectations, there are signs of slowing in some underlying measures for July that could make next month’s release more palatable. And we still foresee the greatest likelihood of a “soft-ish” landing over the next two years, with inflation keeping up pressure on the Fed but growth holding up enough to avoid an outright recession. Rarely has there been a more consequential six-month period for economic outcomes.