A poor first half of the year ended with major equity indexes in bear market territory and bond prices falling at the fastest pace in decades. Concerns about inflation and the implications for monetary policy were at the top of investors' "wall of worries."
With no end in sight to the war in Ukraine and doubts about the outlook for Chinese growth, there was not much good news in the second quarter. The risk of recession is higher than it was at the start of the year, with considerable debate about the potential timing and severity of recession in the U.S.
June's Federal Reserve rate increase of 0.75% was the largest single-meeting move since 1994, a response to inflation that reached a four-decade high in which headline inflation reached 8.6%. The Fed acknowledged that tighter policy will likely lead to higher unemployment and lower economic growth, a necessary consequence of the need to keep inflation expectations from becoming unanchored.
The Fed is justifiably being held accountable for being "behind the curve" on raising interest rates and shrinking the size of their balance sheet. The Fed, however, is not the only culprit for painfully high inflation. The Fed has limited influence over the rising food and energy costs that strain consumer budgets. Rate increases may reduce energy demand, but tight supplies will continue to be the dominant factor driving energy prices.
The tightness in labor markets may be partially attributable to government assistance that has undermined incentives to return to work, as well as the understandable fear of contracting a COVID-19 virus that refuses to fade away.
Inflation is likely to ease later in the year. There are early signs of an easing of wage pressures, a shifting of spending from goods to services, and gradually recovering supply chains. The Fed, however, is not likely to slow the pace of tightening until inflationary pressures recede or a growth slowdown turns into recession. It is quite possible that the "new normal" for inflation will be higher than the Fed's target rate of 2%.
There has been rapid adjustment in financial conditions, in contrast with past Fed tightening cycles. two-year Treasurys yielded approximately 0.25% last June; Yields were nearly 3% at quarter-end. Ten-year Treasurys yielded 1.45% last June and have more than doubled in the past year. The tightening of financial conditions that has already happened may have reduced the typical lag between Fed policy changes and economic activity.
Consumers remain in good shape despite a lot of negative news. The job market remains strong. Wage growth is strong but is slowing from the elevated levels from the post-COVID economic reopening. There is still a significant gap between the number of jobs available and the number of job-seekers. Households have more than $2 trillion in excess savings in comparison with the pre-pandemic trend, a cushion against rising food and energy costs.
Debt servicing costs are near multi-decade lows, in stark contrast with the conditions leading up to the global financial crisis of 2007-2009. Consumer sentiment has declined dramatically, but so far there is a disconnect between what people are saying and what they are doing.
