A recession will likely cure inflation It is my belief that the economy will head into a recession at some point probably in 2023. Given the low unemployment rate and high unfulfilled job vacancies, there is an argument to be made that we're not currently in a recession. I will outline a number of economic indicators that lead me to believe we're heading into a recession over the next 12-18 months.
1) The bond market is telling you.
Economists and other financial experts keep an eye on several different yield curves, but the 10-and-2 yield curve — the spread between the yield on the 10-year Treasury note and the yield on the two-year Treasury note — has been the best predictor of past recessions, Kiplinger reported. It cited Anu Gaggar, global investment strategist for Commonwealth Financial Network, who said the 10-and-2 yield curve has inverted 28 times since 1900, and in 22 of those instances, a recession has followed.
If history repeats itself, we have a chance of a recession well over 50% and the yield curve inversion has preceded a recession just under 79% (22/28*100=~ 79%) of the time.
2) the stock market is telling you.
Both the Nasdaq and S&P 500 are currently in a bear market. Most bear markets have preceded recessions in the majority of cases. There have been 26 bear markets since 1929, but 15 recessions during that time. Bear markets often go hand in hand with a slowing economy, but a declining market doesn't necessarily mean a recession is looming.
3) The fed is going to continue to raise interest rates until inflation is brought back to a 2% target. In order to achieve this, the housing market in both Canada and the US must decline in value or accept the fact that interest rates/inflation will remain stubbornly high. The simple reason for this would be the shelter cost component of the cpi is the largest influence to inflation numbers and with that comes stubbornly high shelter costs. There is a lag between home price appreciation and rents going forward. If home prices increase 20% in one year, then rent over time will have to play catch up over the coming years to be in balance. For instance, suppose it takes 5 years to match home appreciation in the form of rents, then we have approximately 4% rent inflation over the next 5 years. According to Fred, owners equivalent rent is rising very fast and has increased by 0.62% month over month which when annualized works out to 7.69% increase y/y. (1.0062^12 -1)*100 =~ 7.69%
Looking at the Shiller National home price index (Fred) from current levels to Dec 2019 I get an increase of 44% in home values. Interesting to observe the owners equivalent rent has only increased by 10% from current period to Dec 2019. We should expect to see inflation remain stubbornly high until rent catches up to home prices. One solution to fix this problem is for National home prices to fall substantially so that owners equivalent rent growth can get back to normal levels. I think the Fed still has a lot of work to do. We are starting to see significant signs that the Canadian housing market is cooling off with home prices in the greater Toronto area already down ~ 20% from peak levels. Inventory is building up and I expect the same to follow south of the border over the second half of the year.
If and when this occurs, then I see a path to a 2% inflation target for 2024/25.
4) Headline inflation may have peaked but core cpi is likely to rise at least for the month of August and September. If we look at the month of July we get month over month increase of 0.312% which when annualized works out to 3.8%. This is much higher than the current Fed funds rate.
Currently core CPI is up 5.91% y/y but should go up in value over the next 2 months given the lower month over month values for August and September of 2021. Wage inflation remains stubbornly high and will likely remain that way as long as rent prices continue its climb. If your landlord tells you that rent has gone up, then you will likely ask your employer for a pay raise. This price/wage spiral can continue indefinitely and can become entrenched in our economy.
5) Real wage growth is negative implies that consumers have less purchasing power than they did before. When consumers cannot keep up with the cost of living then they may be less incentivized to be productive at work. With wage growth up 5.2% y/y and cpi up 8.5% implies that consumers have effectively been given a pay cut of 3.3%. If your employer cuts your pay, then you can work more hours to offset this difference. In the US we see productivity dropping in the first half of the year. Real gdp has declined even though hours worked increased. This tells me that workers were less productive.
6) In fact, since the 1950s, every time inflation has exceeded 4% and unemployment has been below 5%, the U.S. economy has gone into a recession within two years.
For all of these reasons, I believe we are heading for a recession which will ultimately be the cure to inflation.
https://www.gobankingrates.com/money/economy/how-accurate-inverted-yield-curve-determining-recession/amp/
https://www.hartfordfunds.com/practice-management/client-conversations/managing-volatility/bear-markets.html
https://www.weforum.org/agenda/2022/05/fed-soft-landing-us-economy-recession/