The chart speaks for itself. Market turmoil resumed in June, as inflation data came in hotter than expected. In response, the Federal Reserve hiked interest rates by 0.75% and reiterated its commitment to price stability. In response, both stocks and bonds were lower.
The Fed has a dual mandate: price stability and full employment. There is some inherent tension in pursuing the two objectives simultaneously. At times the pursuit of both is simply not feasible, and trade-offs need to be considered. The present environment seems to be one of those times. Cooling inflation without some uptick in unemployment seems unlikely.
Matters are complicated by the reality that unemployment and inflation measures, like the Consumer Price Index, tend to be lagging economic indicators. Furthermore, the Fed’s tools can be more blunt objects than precision instruments and those tools tend to work with a lag.
Today the “R” word is on everyone’s mind. It used to be that a recession was defined as two consecutive quarters of negative real GDP growth. The current definition is less clear, but it is looking increasingly likely that we met the old definition in the second quarter of 2022. The present economy appears to be one that is growing nominally but contracting on an inflation-adjusted basis.
The good news is that inflation expectations, using market-based measures, have declined significantly since April. Further, we have seen significant declines in a variety of raw material prices from earlier in the year. We could soon be in an environment where nominal GDP is growing more slowly but the gap between nominal and real GDP growth is narrowing.
The pandemic was an economic earthquake and we have been living with the aftershocks for over 2 years. It is possible that, from an economic perspective, getting inflation under control is one of the last shocks to deal with before we transition to an economy that looks more like the pre-pandemic one than anyone thought possible two years ago. Moderate, but acceptable levels of growth, from an investment perspective may not be such a bad environment. The one question is: will there be more aftershocks before we get to that environment? The important thing for investors to remember is that markets tend to recover in anticipation of these issues resolving themselves, rather than because they are resolved.
