There has been little upside surprise this year, so news on Wednesday that annual US inflation – both core and headline – came in below expectations in July is a welcome change.
After coming in a little warm in June at 9.1%, headline inflation fell back to 8.5% in July. While a dip had been expected, consensus estimates of 8.7% proved a touch negative.
Core inflation, which strips out food and energy, came in at 5.9% for July, unchanged from a year ago but a small 0.3% uptick from June. Consensus had been for core inflation to rise 0.5%, month-on-month.
President Joe Biden’s efforts to push petrol providers to more quickly pass on the falling cost of fuel to customers arguably helped cut gasoline prices. After topping out at just over $5 per gallon in mid-June, the average price is now below $4 – albeit by the thinnest of margins at $3.99.
A barrel of Brent crude cost $78.98 at the start of the year, peaked at $127.98 on 8 March – two weeks after Russia’s invasion of Ukraine – and currently sits just under $99.
With the war in Ukraine looking unlikely to end any time soon, and in spite of record profits reported by oil and gas giants, eye-watering energy prices are going to be a key theme for the rest of this year – and probably beyond. Given the significant role they play in calculating inflation, what does this mean for the likelihood the US will enter recession this year?
Is the US in recession or not?
The basic rule of thumb for calling a recession is two quarters of negative GDP growth. But that isn’t the full story. If it were, the US would already be classed as ‘in recession’ after delivering GDP growth of -1.6% in Q1 2022 and -0.9% in Q2, according to Statistica.
The final decision lies in the hands of the National Bureau of Economic Research’s (NBER) creatively named Business Cycle Dating Committee, which monitors peaks and troughs in markets and identifies if declines in economic activity are sector/region-specific.
No committee updates have been published since July 2021, when it confirmed the US had experienced its shortest recession on record between April and May 2020.
Wages too high and unemployment too low
While the NBER committee might make the call about when a recession has arrived, decisions that emerge from the Federal Reserve will likely prove the ultimate trigger. Its record rate hiking spree recently saw 75bps added, taking the federal funds rate to between 2.25-2.5%.
With inflation coming in cooler than expected, the Fed could ease up on its hiking spree, predicts T Rowe Price chief international economist Nikolaj Schmidt.
“Broadly, the Fed is focused on two aspects of inflation,” Schmidt explains. “Expectations – which are highly correlated with oil price/headline inflation – and the cyclical component of inflation – which is heavily driven by the state of the labour market.
“The Federal Open Markets Committee (FOMC) will be happy to see a lower level of headline inflation as this, in its view, reduces the risk inflation expectations become unanchored. Thus, the inflation release removes some of the risks we will see further emergency hikes. This is positive.
“However, core inflation will remain well above the 2% inflation target, which will keep pressure on the FOMC to continue to tighten monetary policy further. In my view, the FOMC is likely to read the inflation release together with the payrolls data, and the information from the payrolls data suggests the cyclical component of inflation is still very much alive – wages are running much too fast, and the unemployment rate is too low.
“Consequently, we see a Federal Reserve still very much in inflation fighting mode and which, most likely, continues to focus on further tightening of financial conditions.
“In my view, the inflation release reduces the likelihood of a recession somewhat, as it gives the Fed some breathing space – ie ‘we do not need the code-red pace of interact rate hikes’. However, the payrolls data for July does exactly the opposite.
“On balance, it seems likely, based on the two data sets, the FOMC will shift to a pace of interest rate hikes of 50bps – which remains fast by historical measures, and which most likely will lead to a rather bumpy landing.”
Squeezed profits, reduced hiring and weak confidence
For Hussain Mehdi, macro and investment strategist at HSBC Asset Management, the positive inflation figures haven’t made much of an impact on the likelihood the US will enter a recession.
“Headline inflation is finally falling on the back of lower energy prices. We are past the worst. But the stickiness of core inflation highlights challenges of tempering inflation in the parts of the CPI basket which are slow to change.
“In particular, services inflation is a thorn in the side of the Fed as consumers rebalance consumption away from goods into services, and amid rising shelter costs. Spending is underpinned by a very robust jobs market.
“All in all, the Fed is set to remain very hawkish, and will be forced to push rates into restrictive territory, a process that may continue into the new year. This alongside squeezed profits, reduced hiring/job layoffs, and weak confidence, is likely to trigger recession.
“For this reason, we maintain a defensive and selective investment strategy with investors potentially overestimating 2023 earnings performance and the ability for the Fed to enact a policy pivot.”
Charles Schwab managing director Richard Flynn agrees. “Whilst [Wednesday’s] inflation rate is below the rate recorded last month; the figure is far above the 2% target. There’ll still be widespread concern about price rises across the economy.
“In recent months, the Fed has been talking and acting tough on fighting inflation – twice raising interest rates by 75bps, taking its benchmark to 2.25% – 2.5%. Investors are likely to ask how high will rates need to go to restore price stability.
“The Fed is indicating it’s likely to keep hiking rates despite widespread signs of an economic slowdown. Indeed, first and second quarter real GDP growth was already negative. Markets are pricing in half-percentage-point rate hikes or more at the Fed’s next four meetings.”
He adds: “Whilst a recession isn’t the Fed’s ambition, it may have already tightened financial conditions enough for one to develop.”
Inflation reduction act
Efforts to stem rising inflation have been key battlegrounds in the US, ultimately resulting in the Senate passing the Inflation Reduction Act 2022 on 7 August after vice president Kamala Harris cast a tie-breaking vote. Its ambitious goal is to “make a historic down payment on deficit reduction to fight inflation, invest in domestic energy production and manufacturing, and reduce carbon emissions by roughly 40% by 2030”.
Only time will tell whether the legislation will prove effective but Paul Ashworth, chief North America economist at Capital Economics, is not convinced, saying it will, “despite its name, do little to rein in inflation, but the climate provisions will make a meaningful difference in efforts to reduce GHG emissions”.
A statement from the latest Close Brothers Asset Management investment newsletter suggests Ashworth is not alone in his views. “The bill is named the Inflation Reduction Act, but the policy contents are a slimmed down selection of the earlier Build Back Better Act, and few will have a significant influence on inflation immediately.”
Whether or not the US enters a recession is dependent on a multitude of factors; not least the myriad data points that determine core and headline inflation, legislative efforts by the government to soften the blow on people’s earnings and the Federal Reserve walking the tightest of tightropes. With this many unknowns, the balance of probabilities leans towards more of a question of ‘when’ the US will enter a recession, not ‘if’.
And even then, it will only be certain once the NBER’s Business Cycle Dating Committee tells us the US is in one.