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April 18, 2022 at 05:19 PM
What You Need to Know
- Energy prices are likely to stay stubbornly high absent a major supply boost from elsewhere or a drop in demand.
- Inflation should return to more manageable levels in the next 12 months.
- The risk of a U.S. recession in 2022 remains low, though 2023 may be a different story.
The near-term market outlook is among the most uncertain in recent memory. War and humanitarian tragedy continues in Ukraine, inflation is at four-decade highs, and the Fed is in the early stages of tightening monetary policy. The market may lack a strong trend until there are more definitive answers to some or all the following four questions:
1. What is the path of the war in Ukraine?
The most likely scenario may be some form of frozen conflict between Russia and Ukraine, worsening the humanitarian crisis and extending the economic uncertainty created by the conflict. Energy prices would stay stubbornly high absent a major supply boost from elsewhere in the world or a substantial downturn in demand. Food and material prices would also remain a problematic source of inflation for many countries. Unfortunately, although geopolitical events typically have not had a lasting impact on markets, this time is probably different. For example, there is likely to be some reversal of the “peace dividend” that boosted equity market valuations in recent decades as geopolitical risk and defense spending rises.
2. How high is the ‘new normal’ for inflation?
There may be better news about inflation. Although the war will contribute to inflation remaining stickier than previously anticipated, inflation should return to more manageable levels over the next 12 months.
Vehicle prices represent nearly 12% of the core consumer price index and have been a major contributor to skyrocketing inflation. New vehicle prices have risen 14% since the start of the pandemic, while used car prices rose more than 50% as rental firms rebuilt their inventory. With the shortage of new and used cars easing, vehicle price inflation should slow and could even turn negative.
Wage growth may also slow down if there is a continuation of the recent improvement in labor participation that narrows the gap between jobs available and those actively seeking work. Although inflation will likely remain above pre-pandemic levels, the Fed and investors may declare “victory” if inflation gets down to 3%.
3. Will the Fed make a policy error?
Investors are concerned that in the haste to correct overly expansionary monetary policy, the Fed will overcorrect and cause a recession. The most troubling aspects of today’s inflation, however, are supply-side challenges largely beyond the Fed’s control. The Fed can’t replace the oil and gas supplied by Russia, provide wheat and fertilizer to feed the world, or unclog supply chains.
A portion of today’s elevated inflation is a function of the composition of demand rather than the aggregate level of demand, which is an important distinction. The Fed’s recent interest rate increase and policy signals communicate a commitment to fighting inflation, but the central bank has left itself room to slow the pace of rate increases and balance sheet reduction if conditions warrant a slower pace of policy normalization.
