[Last year was] a volatile one for the economy and the financial markets. The main factors that drove uncertainty in 2022 remain the same as we enter 2023 — the stubbornness of inflation and its effect on the Fed’s interest rate policies, and the looming threat of economic recession and its impact on corporate earnings. All are interrelated.
The main catalyst of uncertainty has been the persistent and pervasive nature of inflation. In response, the Federal Reserve has embarked on an historically aggressive monetary policy change that has quickly and significantly increased interest rates. This change in monetary policy clearly dampened economic activity. The first and second quarter GDP were negative (-1.6 percent and -0.6 percent) while the third quarter GDP rebounded to 2.9 percent. The economy limped into year-end and overall GDP growth will be modest, at best, in 2022. For 2023, the consensus forecast for GDP growth is sobering, with a 60 percent-plus chance for a recession in the first half of the year.
In the post-COVID economy, it was hoped that inflation would be “transitory.” Unfortunately, inflation continues to remain problematic heading into 2023. The good news is inflation, as measured by the Producer Price Index (PPI) and the Consumer Price Index (CPI), appears to have peaked. PPI peaked at 11.7 percent in March and was 7.4 percent in November. CPI posted a peak rate of 9.0 percent in June and was 7.1 percent in November. Both indices have declined every month since their peaks. While this trend is encouraging, inflation remains far above the Fed’s 2 percent target. There continues to be three primary drivers of these pessimistic inflation expectations: supply chain disruptions, commodity prices and labor issues. While some of these factors have improved, others still are a significant concern.
Yet, a positive: supply chain disruptions have improved. At the outset of the COVID pandemic, a dramatic shift in consumer demand severely affected the supply chain. In “normal” circumstances, the U.S. economy is driven by the service sector. With the COVID lockdown, consumer demand shifted significantly to goods. While we were in lockdown, we refurnished the house, finished the basement, and replaced the appliances. This dramatically increased demand for commodities and finished goods. The supply chain buckled under this change. Demand is now shifting back to “normal,” meaning the consumer has returned to buying services instead of goods. Afterall, how many new refrigerators can one buy? We are back in restaurants and hotels and air traffic is at record levels. This shift in demand has allowed “goods” inflation to decline and commodity prices to fall significantly.
Another area of inflation improvement is the housing market. Clearly, the dramatic increase in mortgage rates from less than 3 percent at the start of 2022 to roughly 6.5 percent today has impacted housing activity. Existing home sales have declined for nine consecutive months and that has allowed home prices to decline.
Unfortunately, inflation remains problematic in one area: the service sector. Services represent nearly two-thirds of the economy, and services inflation is driven by one key factor — labor costs. And the labor market remains tight. November’s unemployment rate was a historically strong 3.7 percent. Unfortunately, this low rate is misleading and masks what is a challenged labor market. The labor participation rate (62.1 percent) has yet to recover to pre-COVID levels. The JOLTS (Job Opening and Labor Turnover) report shows there are 10.3 million job openings — nearly 1.9 times the number of unemployed individuals. The National Federation of Independent Business (NFIB) Jobs Report states that 90 percent of small businesses report few or no qualified applicants for open positions. As a result, wage inflation has been growing more than 6 percent. This dysfunctional labor environment suggests that wage inflation will remain problematic in 2023, particularly in the small-business economy of NBT’s footprint.
The Fed has responded to persistent inflation by aggressively increasing the Federal Funds interest rate. Since March, the Fed Funds rate has increased from 0.0 percent to 4.75 percent. This is an historically fast pace for the Fed. To provide some perspective, the last time the Fed embarked on a prolonged rate-hike strategy, it raised rates by 3.25 percent over the course of three years (2010-2012). In addition, the Fed continues to reduce the size of its balance sheet, i.e., quantitative tightening, and that has an ongoing tightening impact. However, the Fed is in a difficult spot. The aggressive policy clearly has slowed the economy, but service inflation remains problematic. This may force the Fed to raise rates further and then maintain them at a higher level for a longer period of time, increasing fears that they will “go too far” and force the economy into recession. Indeed, the slowing economy and the threat of a recession has challenged the financial markets. Both stocks (S&P 500 -20 percent) and bonds (-12 percent) posted significantly negative returns in 2022 due to the double whammy of rising interest rates and declining earnings.
The economy has already reacted negatively to this aggressive change in monetary policy and uncertainties abound for 2023. Housing activity has been materially impacted. Industrial commodity prices have declined. Manufacturing activity has slowed. M2 money supply (the Fed’s estimate of total money supply, including cash, checking deposits and non-cash assets that can easily be converted into cash) has declined significantly, and the 2–10-year Treasury yield curve is inverted by 50 basis points, both historic indicators of recession. Indeed, consensus economic forecasts suggest a 60 percent-plus probability of a “short and shallow” recession in the first half of 2023.
The direction of the economy and the financial markets will be determined by inflation. If recent trends continue and wage pressures abate, inflation may decline toward the Fed’s 2 percent target. This would allow the Fed to complete its interest-rate hiking cycle. With the fear of further rate hikes over, the economy would be poised for renewed growth. With stable rates, corporate earnings may begin to grow again. However, the main risk for 2023 is that inflation will remain stubborn. That would require the Fed to raise rates further and keep them “higher for longer” — something the economy and the markets are not anticipating.
Reflecting these fears, the consensus economic forecast calls for a modest recession in the first half of 2023. Hopefully, any recessionary activity will be muted by strong corporate and consumer balance sheets. The expectations are for a rough start to 2023 as the economy works through the challenge of tight labor markets and persistent inflation. It is hoped that inflation will dissipate in the first half, setting the economy and the markets up for a strong second half of 2023.
Author’s note: This article contains insights based on information available as of Dec. 29, 2022.
Kenneth J. Entenmann is chief investment officer and chief economist at NBT Wealth Management, a unit of NBT Bancorp (NASDAQ: NBTB). He oversees more than $6 billion in assets under management and administration in trust, custody, retirement, institutional and individual accounts. Entenmann regularly shares his perspectives on the economy on his Market Insights blog at www.nbtbank.com/marketinsights.