Signs of economic weakness are piling up, but many economists and strategists are sticking to their predictions of soft landing. A new inflation target may be the only way they can be right – and it would come at a disregarded price.
Data from the past week included a worse-than-expected decline in pending home sales, to the lowest level since 2014 and signaling more pain because they are leading the sale of existing homes. Households have been saving at the slowest pace since 2008, Purchasing Managers’ indices showed larger-than-expected slowdowns in both manufacturing and service activity, the four-week moving average of unemployment applications rose for the eighth week in a row, and the Federal Reserve Bank of Atlanta’s second-quarter GDPNow tracker fell to $ 1. 9% from an earlier estimate of 2.4%.
All of this is happening as corporate inventories rise, redundancies rise, and the revised gross domestic product report for the first quarter showed that corporate profits fell for the first time since the end of 2020. Based on forward-looking business statements, profits will fall again in the current quarter, says Nancy Lazar, global chief economist at Piper Sandler. Her company’s daily tracking of consumer confidence fell to a new recession during the week.
Yet much of Wall Street is still confident that the U.S. economy will continue to grow as the Fed tightens monetary policy to combat a four-decade high in consumer price inflation – although soft landings are rare, and despite the Fed’s President Jerome Powell recently switched from “soft” to “soft” and then to “uneven” and involves “some pain” when describing how the economy will land.
There is one way to tighten Fed policy – where the balance sheet contraction starts in June, when interest rates rise another half point in the midst of already declining growth – with recession avoidance. Inflation would remain high because the Fed is stopping fighting it.
Consider analysis from Solomon Tadesse, Head of Quantitative Equity Strategies North America at
about what it takes for the Fed to reach its goal. To halt inflation, he says, it could take an overall monetary tightening of up to 9.25%, with the primary policy rate rising to 4.5%. The balance would come from a quantitative easing of about $ 3.9 trillion – reversing two-thirds of the emergency bond purchases the Fed has made over the past two years, reducing the Fed’s balance by almost half.
But it probably will not happen. “They keep talking about 2%, but the price may be too high,” said Ed Yardeni, president of Yardeni Research, referring to the Fed’s long-term inflation target. He predicts that when price inflation cools to around 4%, the central bank will signal that it will lift its target and thus stop tightening faster than many investors think.
Rent is a major driver of Yardeni’s vision. While the demand for housing decreases as interest rates on home loans rise, prices continue to rise. Shelters make up about a quarter of the personal spending index, the Fed’s preferred inflation gauge, and 40% of the consumer price index. Rick Palacios, research director at John Burns Real Estate Consulting, says prices of existing homes and new homes will continue to rise by 8% and 6% respectively this year. As rents lag behind house prices by 12 to 18 months, these forecasts suggest that rents will remain high even as housing cools. Aside from causing a “severe recession,” there’s not much the Fed can do about rent inflation at this point, Yardeni says.
So far, former and current Fed officials say the 2% target is sacred. Finance Minister and former Fed Chairman Janet Yellen recently rejected the idea of a higher inflation target. Powell has expressed a commitment to bring inflation back to 2%, and formal policy statements repeat this target.
But Yardeni is not alone in his view. In a Bloomberg TV interview earlier this month, New York University professor Paul Romer said the Fed would be better off with a stable inflation target of 3% to 4%.
Chief Financial Officer Mohamed El-Erian told CNBC in April that the Fed could be forced to raise its target, given how far behind the inflation curve it had fallen.
Sustained shelter inflation is not the only reason to suspect that a higher inflation target is on the table. Tim
partner at Pennant Investors, points to the transition to green energy as well as potential initiatives by US manufacturers to bring supply chains closer to home. On the former, he says there will be a years-long disruption of supply and demand before a green system can replace the current one. As for the latter, McDonald notes (saying that his views do not represent his firm’s) that even a partial reversal of globalization would lift a decade of inflationary slump, as companies face higher labor costs and other costs associated with relocating production.
The point, McDonald says, is that the U.S. economy is in a period of higher structural inflation, making the 2% target obsolete. “As I look at it as an investor, I look at it as if we are in a period of transition. I do not know how long it will last, but I can tell you that it is not in quarters. ”
Data on Friday showed that the PCE excl. food and energy cooled to a 4.9% year-on-year pace in April, from 5.2% a month earlier and represented the slowest pace this year. That is well after the 6.2% rise in the April core CPI and not far from the 4% that Yardeni and others mark as a possible new target. Critics say PCE is problematic. Healthcare is heavily weighted in PCE, and Medicare and Medicaid reimbursement rates set by the government and thus artificially depressed make up most of it, says Peter Boockvar, chief investment officer at Bleakley Advisory Group. Aside from the criticism, the reality is that the Fed is using core PCE to set policy and it can cool to 4% faster than valued.
It is unclear how a higher inflation target will affect the economy and markets because there are different moving pieces. Tadesse from Société Générale says that raising the target would be negative for both equities and bonds because it would dispel inflation expectations, which in turn would raise prices and potentially create more pain later. McDonald of Pennant notes that higher inflation benefits borrowers at the expense of creditors. Then there is the idea that a higher inflation target would mean lower interest rates, which in a vacuum should increase the present value of companies’ future free cash flows and strengthen growth stocks in particular.
If the US economy is to avert a recession, there is something to be gained. That may very well be the Fed’s inflation target.
Write to Lisa Beilfuss at firstname.lastname@example.org