Inflation will drag down growth, but US should avoid recession this year

Persistent inflation, widespread uncertainty and an increasingly hawkish Fed have spurred concerns that the US economy could slip into recession
While the risks of a severe downturn have risen, strong corporate and household balance sheets should provide a buffer against tighter financial conditions

Sylvia Sheng

Published: 1:30am, 4 Jun, 2022

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The relationship between inflation, growth and monetary policy has been a key driver of equity market performance recently. As the US Federal Reserve continues to raise interest rates in an effort to steer inflation towards its 2 per cent target, investors have started to worry about the negative impact on US growth, which has led to sharp corrections in US equities since April.

The seven-week losing streak on the S&P 500 index, the longest run of weekly losses since 2001, ended last week. Investors have dialled back their expectations of aggressive monetary tightening by the Fed amid weaker economic data and signs that US inflation might have peaked.

The US inflation picture has changed significantly in recent months. The rapid rise since mid-2021 has been driven mainly by higher goods prices caused by a sudden surge in consumer demand for physical products when factory output was constrained. One prominent example is used car prices, which surged in the past year because of tight supply.

In the past few months, US inflation has been showing signs of a widespread economic overheating, particularly with the rise of prices in services. Prices of core components hit above a 5 per cent annualised rate in April. Rising wages in a tight labour market have put further pressure on services inflation.

At the same time, economic reopening unleashed pent-up demand in services consumption such as tourism. Meanwhile, core goods prices – those that exclude food and energy – are no longer rising sharply, but they have fallen short of expectations that they would ease this year.

March data shows US inflation woes could be near their end

While the year-on-year US inflation rate has started to fall, the monthly pace continues to be above the Fed’s target. In fact, the average US core inflation rate between February and April annualised to around 6 per cent. The broad-based acceleration in services inflation, combined with strong wage gains, suggests that inflationary pressure in the US is unlikely to dissipate on its own.

In addition, the outlook for goods inflation is uncertain, given supply chain disruptions from the Russian invasion of Ukraine and Covid-19 restrictions in China. Even if we see a drop in overall US inflation because of lower prices of goods, the Fed will remain concerned if services inflation continues its rise.

Thus, it seems increasingly evident that bringing down inflation will require a period of weaker growth. The Fed is likely to stick to its current policy trajectory, which has already been priced in by the market, raising the federal funds rate to roughly 2.75 per cent.

This view is supported by the May Federal Open Market Committee minutes, which affirmed that the Fed needed to raise rates to the neutral level quickly to contain inflation. The committee seems to be focusing on inflation, suggesting it remains confident the US economy can withstand higher interest rates.

Jerome Powell, chairman of the US Federal Reserve, speaks during a news conference following a Federal Open Market Committee meeting in Washington on May 4. The Fed has raised interest rates by the steepest increment since 2000 and decided to start shrinking its massive balance sheet. Photo: Bloomberg

Financial conditions have already tightened in the US since the start of this year in response to the Fed’s increasing hawkishness. In the past, this has been associated with slower growth, with a lag of two to three quarters. Thus, the impact of the financial tightening is likely to become more evident from late 2022 to early 2023.

Which part of the economy will be affected most? Housing activity will probably be the first to feel a chill, a process that already appears to be under way.

Demand has fallen each month this year, according to a survey by the National Association of Home Builders, with a particularly sharp decline in May. Home sales have also slowed. Capital investment might have a limited impact, although it has not been as sensitive to higher interest rates. Companies have tended to finance investment from cash flows rather than borrowing.

The key question for investors is whether Fed monetary tightening to contain inflation will push the US economy into recession, potentially leading to further declines in equities. While recession risks have risen, strong corporate and household balance sheets will provide a buffer against tighter financial conditions.

How realistic is it to expect a soft landing for the global economy?

That said, the base case for the US economy remains slower growth but no recession this year. It will be important to monitor lay-offs and corporate capital investment plans to assess any risk of a steeper downturn.

Consumers have navigated the inflation shock well, thanks to strong income growth, and any prospect of employment insecurity could prompt a precautionary rise in savings. Moreover, if capital investment growth expectations suddenly fall, that might signal a broader pullback in expansionary economic behaviour.

Sylvia Sheng is a global multi-asset strategist at JP Morgan Asset Management

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