Inflation Shocks to Recession Fears
Fixed Income Insights
Key Takeaways
A blend of structural (more permanent) and cyclical (more temporary) factors have propelled inflation to multidecade highs.
While the Fed’s efforts to ease the cyclical drivers of inflation are progressing, we believe it’s unlikely the central bank can tame inflation without triggering a recession.
We expect mounting recession fears to prolong volatility, underscoring our more cautious approach to fixed-income allocations.
Top of Mind
Through the first half of 2022, investors grappled with elevated and rising inflation not seen since the early 1980s. In June, for example, the Consumer Price Index climbed to 9.1%, its highest point since November 1981. In our view, a combination of structural and cyclical factors is to blame for today’s persistently high inflation rate.
The structural factors fueling inflation include the reemergence of labor leverage, receding globalization and the rise of ESG as a policy initiative. Cyclically, the massive liquidity the Federal Reserve (Fed) and the U.S. government pumped into the economy in response to COVID-19 continues to bolster inflation. Additionally, COVID-19-related disruptions stressed global supply chains, and the Russia/Ukraine war has only exacerbated the situation.
In response to the inflation backdrop, global central banks began tightening monetary policy, although belatedly. Led most aggressively by the Fed, policymakers started raising rates and reducing balance sheets to dampen inflation and restore their inflation-fighting credibility.
Economic Worries Gaining Momentum
While inflation likely will remain a major factor for investors in the second half of 2022, we believe fears of an economic slowdown and possible recession will take hold. Ultimately, the likelihood of a recession in the U.S. and other developed economies will depend on the magnitude of the central bank tightening necessary to tame inflation.
As Figure 1 illustrates, we expect headline and core inflation to moderate over the next 12 months. As supply chains improve, particularly in the energy and food sectors, we believe pricing pressures may ease.
Nevertheless, we expect inflation to remain significantly above the Fed’s 2% target. Given our expectations for more persistent inflation, the implications for Fed policy are clear: Policymakers will need to tighten financial conditions until they orchestrate a slowdown in demand.
Figure 1 | Inflation May Ease Over the Next 12 Months
Year-Over-Year June 2022 (%) | Year-Over-Year Baseline Estimate July 2023 (%) | |
|---|---|---|
Consumer Price Index (CPI) | ||
Headline | 9.1 | 4.0 |
Core | 5.9 | 4.2 |
Main CPI Subcomponents | ||
Food | 10.4 | 6.0 |
Energy | 41.6 | -7.4 |
Shelter | 5.6 | 4.8 |
Medical Care Services | 4.8 | 4.3 |
Recreation Services | 4.7 | 4.2 |
Transportation Services | 8.8 | 4.0 |
All Core Services | 5.5 | 4.0 |
Personal Consumption Expenditures (PCE) | ||
Headline | 6.3 (May) | 3.2 |
Core | 4.7 (May) | 2.9 |
Sources: Bureau of Labor Statistics (CPI) and Bureau of Economic Analysis (PCE). Forward baseline estimates based on American Century Investments Global Fixed Income team analysis as of July 26, 2022.
Fed’s Strategy Progressing
To date, the Fed has made progress in tightening financial conditions and slowing monetary growth. As Figure 2 highlights, the Goldman Sachs Financial Conditions Index has climbed to the levels of 2018, the last time the Fed was tightening monetary policy.
Additionally, growth in the nation’s money supply has slowed. After expanding at a pace of 27% in early 2021, money supply growth moderated to 8% recently, as Figure 3 demonstrates.
Figure 2 | Financial Conditions Tighter, Reaching Levels of Fed’s Last Rate-Hike Cycle
Data from 6/30/2017 – 6/30/2022. Source: Bloomberg. Goldman Sachs Financial Conditions Index, a weighted average of riskless interest rates, the exchange rate, equity valuations and credit spreads, with weights that correspond to the direct impact of each variable on gross domestic product (GDP). Higher index levels indicate tighter financial conditions, lower index levels indicate more accommodative financial conditions.
Figure 3 | Growth in U.S. Money Supply Is Moderating
Data from 6/30/2017 – 6/30/2022. Source: FactSet. M2, which includes cash, checking and savings deposits, money market securities and highly liquid time deposits.
Cooling Demand May Require More Aggressive Action
Despite this progress, the Fed still has a difficult task ahead. Thanks to several years of loose fiscal and monetary policy, the economy continues to exhibit an abundance of excess demand.
Furthermore, the U.S. unemployment rate was 3.6% in June, below the estimated natural unemployment rate of 4.5%.1 This implies the Fed needs to be more aggressive to cool down the excess demand shock lingering in the economic system.
Given the combination of a persistently high inflation rate and a low unemployment rate, we believe the Fed may need to raise rates well beyond neutral (estimated to be 2.50%). At the Fed’s June monetary policy meeting, policymakers suggested the federal funds rate target would peak at 3.8% in 2023.
Recession, Heightened Volatility Are Likely Outcomes
Ultimately, we believe it will be difficult for policymakers to fine-tune monetary policy to avoid recession. With a mix of supply and demand shocks feeding inflation, the Fed’s task remains particularly complicated.
Given the unprecedented uncertainty surrounding future inflation and interest rates, we expect markets to remain quite volatile in the months ahead. However, we believe the broad market focus will transition from inflation shocks to recession fears.
As such, we remain cautious in our duration posture and credit selection, favoring more liquid, higher-quality segments of the bond market.
Authors
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The natural rate of unemployment represents the lowest unemployment rate at which inflation is stable.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.