The Coming Recession and The Federal Reserve

Rich Colman

Although the US economy has had two consecutive negative quarters of GDP Growth, inflation continues to ravage the economy with a flavor similar to the US experience of the 1970s. During that period, the Federal Reserve would raise interest rates for a period and then, due to rising unemployment and political outcry, ease them again. The lack of consistency resulted in the eventual situation of Stagflation.

The experience of the 1970s puts enormous pressure on the Federal Reserve to maintain high interest rates even if the US economy is pushed into a recession. Today we have a similar situation facing the Fed: interest rates keep rising and we believe the next meeting will raise rates a minimum of 75 basis points and possibly 100 basis points.

In a recent speech in Jackson Hole, WY, Fed Chair Jerome Powell announced that he will do whatever it takes, pretty much to the exclusion of economic growth and better market returns, to drive inflation down to the 1.8% annual goal that has been recent Fed policy. He said, bluntly, that “reducing inflation is likely to require a sustained period of below-trend growth.” Translated, that means higher short-term bond rates, and a wave of businesses firing workers. So far, we have seen higher bond rates but not large-scale layoffs.

There are two main forces driving the current rise in inflation: fossil fuel prices due to the War in Ukraine, and a lack of eligible workers in the US. We are seeing the two forces combine to make bringing down inflation difficult. Although businesses have cut back on hiring and some sectors have started laying off workers, the shortage of workers is still visible in the August numbers on employment, unemployment and job openings reported by the Federal Government’s Labor Department.

With the war grinding on in Ukraine, we do not forecast Russian fossil fuels entering the West’s market in 2022 or early 2023. We do see that Russian fossil fuels sold to India and China have just about equaled the amount of fossil fuels Europe is no longer purchasing from Russia. The oil shortage has pushed up prices enough that as of late June, Russia continues to receive approximately $6 billion a month more in fossil fuel revenues, despite steep discounts in sales to India and China.

Currently, we do not see Russia running out of revenues to fund its war. Therefore, the Federal Reserve Bank must reduce demand. With such low unemployment and continued mismatch of job openings to employees, the Federal Reserve Bank may be forced to push the US into a hard recession with massive layoffs.

Jerome Powell’s speech seemed to hint at another 75, possibly 100, basis-point increase, in the Fed Funds’ Rate later this month. If (when) that happens, it will grab headlines. However, the most significant growth-slowing measure the Fed has undertaken may be Quantum Tightening (QT). Quantum Tightening is the name of the process by which the U.S. central bank is selling off the treasury and mortgage bonds on its balance sheet. The Federal Reserve has stated that it is doubling the monthly sales from $47.5 billion to $95 billion. It’s important to note that when the Fed was buying these bonds, the so-called QE (quantitative easing) buoyed the stock market. QT might have the opposite effect and cause the US equity market to drop significantly. Currently, it is unknown what effect the selling of the treasury and mortgage bonds will have on the stock market, but it is another uncertainty.

Despite all uncertainty in the near future, most of us know that the economy will eventually recover from its current doldrums, and the Fed’s current policy will ease up, after inflation has declined as it has for more than 100 years. What we’re seeing now is the inevitable decline in the stock market which is predating the actual slowdown in the US economy. We expect to see an easing of the Federal Reserve Bank’s policy once there are more workers seeking employment than openings, and the economy activity slows further. We can only hope that the reduction in inflationary forces occurs sooner than later, so Federal Reserve can again prioritize growth and profitability in the economy over combatting inflation.

Sources:
https://www.advisorperspectives.com/articles/2022/08/31/powell-abandons-soft-landing-goal-as-he-seeks-growth-recession
https://www.advisorperspectives.com/articles/2022/08/31/the-fed-is-about-to-go-full-throttle-on-qt-fear-not
https://numbernomics.com/unemployment-vs-job-openings-2/
https://www.nytimes.com/2022/06/21/world/europe/ukraine-russian-oil-embargo.html