Photo / Courtesy of NBT Bank
Kenneth J. Entenmann, NBT Bank.
October 21, 2022
With persistent inflation, economy is in search of a soft landing
By Kenneth J. Entenmann, NBT Wealth Management
In my last Mainebiz article from March of this year, I worried that inflation would remain “pervasive and persistent.” Unfortunately, that has been the case.
Six months later, despite the Federal Reserve Bank’s significant increases in interest rates, inflation remains at unacceptably high levels. The year-over-year Producer Price Index (PPI) for September was reported at 8.5%; the year-over-year Consumer Price Index (CPI) for September was reported at 8.2%.
The three drivers of inflation discussed in our March article are still present. Supply chain disruptions have improved. Consumer demand continues to return to “normal,” meaning the consumer has returned to purchasing services instead of goods. Inflation on goods, such as appliances, furniture, home improvements and electronics have subsided. That has allowed most commodity prices to decline — that’s the good news.
The bad news is that prices for services have spiked. Just ask anyone who has purchased an airline ticket or went on a vacation. This week, the CEO of Delta Airlines spoke of continued significant demand for travel. Disney announced an increase in theme park prices, and Pepsi had terrific earnings as the company has been able to pass input prices on to the consumer. Inflation for “services” remains hot.
The labor market remains tight. September’s Unemployment Rate was 3.5%. Unfortunately, the Labor Participation Rate declined to 62.3%.
On a recent trip to our NBT Bank regional headquarters in Portland, I couldn’t help but notice the ubiquitous “Help Wanted” signs on Commercial Street. Real estate developers I spoke with expressed concern that skilled labor remains difficult to find. While an agricultural business owner is struggling to find any labor, skilled or unskilled.
Lastly, while energy prices have declined from their peak, they too remain elevated. Actions such as distributions from the Strategic Petroleum Reserve and the suspension of state and local gasoline taxes have helped. However, a massive supply-demand mismatch remains, and it will take years to fix.
The good news is that there is a case that inflation may have peaked. Most of the inflation numbers peaked in March of this year. September’s 8.5% PPI is below August’s 8.7% and peaked in March at 11.7%. September’s 8.2% CPI is below August’s 8.3% and June’s 9.0%. The bad news is these numbers remain elevated and far above the Federal Reserve Bank’s stated target of 2%.
The Federal Reserve Bank has responded to this low unemployment and persistent inflation by tightening monetary policy. As always, the hope is the Fed will manage a “soft landing,” where they raise rates just enough to snuff out inflation while at the same time not forcing the economy into a recession. The Fed started with a 0.25% increase in the Federal Funds rate on March 16. It has followed that hike with three consecutive increases of 0.75%, raising Fed Funds to its highest level since 2008. The markets are anticipating that the Fed will raise rate another 0.75% in November and perhaps 0.50% in December.
The concern for the economy is that the Fed’s rate hike schedule has been too aggressive. Historically, the Fed takes its time while raising rates. In the last rate hike cycle, coming out of the Great Financial Crisis of 2008, the Fed raised rates to 3.25% in .25% increments over three years from 2010 to 2012. In 2022, the Fed has raised rates from 0% to 3.25% in six months! There is a high probability of another 1%+ increase by the end of the year. That is a world record pace for the Fed. But is it too far and too fast?
The answer to that question is elusive. September’s data shows inflation to be persistent and pervasive. Following the release of the most recent data, the market anticipates that the terminal rate — the level of Fed Funds at the peak of the rate cycle — has increased from 4.25% to 4.5% to 4.8% to 5%. However, monetary policy works on the economy with a lag. Clearly, the economy has already slowed due to the Fed. Existing home sales have declined for eight consecutive months and prices are beginning to decline (albeit modestly). The ISM Manufacturing Index unexpectedly fell to 50.9 in September, the slowest growth in factory activity since 2020. Commodity prices, including oil, have declined meaningfully from their early year prices.
The Fed continues to talk tough on inflation despite a dramatic fall sell-off in the equity markets and significantly higher interest rates across the yield curve. This raises the fear that the Fed’s inflation fighting rate hikes will force the economy into recession. While the Fed continues its search for a soft landing, the markets are increasingly fearful the probability of a recession in 2023 is growing.
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