Notes on the Economy – Q3 2022 Summary

THE FED’S NOT BLUFFING

Real GDP fell an annualized 0.9% in the second quarter of 2022 following a drop of 1.6% in the first quarter. The two-quarter drop conforms to the notion, popularized in the media, of an economic recession. However, it is doubtful that the National Bureau of Economic Research, the private nonprofit research organization which is widely recognized as the arbiter concerning the occurrence of U.S. recessions, would call the first six months of 2022 a recession. During that period industrial production increased at a 5.2% annual rate while nonfarm payrolls increased by 2.7 million. Those two numbers alone show the absence of a broad-based decline in economic activity, which is the essential element of a recession. So, the U.S. economy is not in a recession—not yet anyway.

Still, the economy is not in a good place. Although real GDP has been weak, some parts of the economy are stretching capacity and inflation has soared. Unemployment is a mere 3.5%, and there are nine job openings for every five unemployed persons actively looking for work. Over the last twelve months the Consumer Price Index for All Urban Consumers (CPI) increased 8.5%. Labor costs are surging upward with compensation per hour rising an annualized 5.7% and unit labor costs 10.8% in the second quarter. Production bottlenecks and supply shortages, the fallout of disruptions caused by COVID-19, and by the Russo-Ukraine conflict, though easing, have not vanished. Further, these same sets of problems, anemic GDP growth, supply chain disruptions, labor shortages, and sky-high inflation are evident in many economies around the globe.

HEADLINES – WHAT’S IMPORTANT

• External Threats to the Economy Have Not Vanished – The COVID-19 threat to life, health, and the economy lingers, while Russian threats—e.g., to Ukrainian nuclear power facilities, and for a winter cut off of natural gas supplies to Western Europe—have become more dangerous.
• Global Interest Rates Are Advancing – The Federal Reserve (Fed) policymakers appear uniform in their determination to stop inflation through tighter financial conditions. The probability of overdoing it has risen.
• Coming up for Air – The June-August rally in U.S. equities prices is typical of a mid-bear market event; corporate operating and financial risks remain elevated.
• Precious Metals Are No Bargain – Precious metals can function in a limited capacity as portfolio insurance, but the opportunity cost in terms of forgone potential returns elsewhere is material.

LOOKING AHEAD

Recent speculation embodied in fixed income yields and futures markets to the effect that interest rate increases could soon reverse course is misplaced. The Federal Reserve (Fed) has clearly telegraphed an intent to bring inflation under control. The Fed is not bluffing; it has a full house of voting members on its Federal Open Market Committee (FOMC—its monetary policy setting arm) who express a sentiment to do whatever it takes to lower inflation to 2.0% on a sustainable basis. Thus, the federal funds rate (the Fed’s policy rate) will be lifted high enough to engineer growth of economic output at a rate that is slower than the growth of productive capacity, even at the risk of recession. It is uncertain what this may be, but it is reasonable to expect the Fed will lift the federal funds rate into the neighborhood of 3.5% by the end of 2022 or early 2023 and keep it there until policymakers are confident that its inflation target can be achieved—probably not before late 2023.

As noted above, many of the world’s economies face the same set of problems as the United States. It is not surprising then, that monetary policies are being tightened around the world, while the outlook for global growth has deteriorated during 2022. The International Monetary Fund (IMF), for example, recently downgraded its expectations for world growth from 3.6% to 3.2% for 2022 and from 3.6% to 2.9% for 2023. Emerging market (EM) economies should grow 3.6% and developed economies 2.5% in 2022, down 0.2 percentage points and 0.8 percentage points, respectively, from the IMF’s previous forecasts. However, even the IMF’s downgraded forecasts appear to be on the optimistic side. It now forecasts growth for the U.S. economy of 2.3% in 2022, for example, whereas AMG projects 1.5%.

* The information contained within this edition of the Notes on the Economy Executive Summary is based on data released as of August 25, 2022.

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