Is inflation truly on a path back to the Fed’s target of 2% or is there still more work to do?
That is the big debate in Fed policy circles as well as among economists of all stripes. The implications are important due to the outsize influence the Fed’s policies have on our markets. With many economists predicting recession and the Fed’s reputation for its actions being behind the curve, we’re in a delicate place as it relates to monetary policy. The Fed finally hit pause on their interest rate hikes in June. However, they have signaled they still believe they’ll need to raise rates further to tame inflation. Headline inflation came in at 4.0% in May, which is down from a peak of 9.1%, but it is still double the Fed’s target. While the Fed’s interest rate policy gets the bulk of attention, their actions behind the scenes to tighten the money supply arguably have just as much, if not more, influence on the economy.
After a huge blowout of +40% growth following the pandemic, a key measure of the overall money supply, M2, has been declining on a year-over-year basis, and is most recently down about 4% year-over-year based on May’s data. A contraction in the money supply of this magnitude has not happened in decades and is one of a number of indicators pointing toward recession.
The standard definition of inflation is too much money chasing too few goods. With that in mind, the contraction in supply of money should be a good thing in bringing inflation under control. However, in our opinion, the whiplash in policy coming from the Fed is proving the fallacy of having such a small group make decisions for an economy as broad and dynamic as ours. The extended pain of inflation is also reminding many observers why it is so important to ensure inflation doesn’t get out of hand in the first place.
Through the first half of this year we have seen a good bit of conflicting data as it relates to the overall economy. Headline jobs numbers have continued to come in strong, although underlying data suggests there has been a shift towards restaurant and healthcare services while technology has started shedding jobs. GDP growth has continued, albeit slowly, while an alternative measure of the economy, GDI, has seen two consecutive quarters of contraction. Retail sales have remained positive, however they become negative once you factor inflation. Household incomes continue to increase, but mostly in line with inflation, thus negating any boost in spending power. Manufacturing has continued in contraction territory, while services have continued to grow (although this has been slowing). The unemployment rate ticked up in June, but still remains at a subdued level. The stock market has had a small bounce back (mainly attributed to a handful of tech names), but corporate profits are negative year-over-year. Home sales generally are down significantly with the rise in interest rates, but seem to be stabilizing and may have found a bottom. And while it seems we may be through much of the banking crisis, banks have now tightened credit conditions fairly significantly which is also a condition that tends to precede recessions.
Another factor that is likely to ripple through the economy is the end to one of the remaining pandemic policies: student loan forbearance and the Biden administration’s loan forgiveness plans being held unconstitutional by the US Supreme Court. While not discussed much, those owing student loans to the federal government have not had to make payments for 3+ years. Now that is coming to an end, and they will have less money to spend in other areas of the economy, creating a potentially sizable headwind in the coming months.
All of this points to us continuing to be defensive in the coming months. While we cannot ignore the bounce back in tech stocks in particular, and we maintain allocations to growth stocks generally, this is still a story of taking yield where we can and ensuring we are well positioned should these negative signals continue or grow and the economy truly hits a recession.