Inflationary pressures ease, economic outlook improves

Khanchit Khirisutchalual

The stock market rally that began in mid-June was fueled almost exclusively by the realization that the risk of excessive Fed tightening in order to fight inflation has diminished significantly. This awareness, in turn, was prompted by a growing body of evidence that points to a noticeable decline in inflationary pressures: an impressive slowdown in M2 growth this year (which I last documented here), a rather impressive massive sell-off on the commodity markets (Chart n°5 in this post), and a sharp cooling in the real estate market (a sudden slowdown in housing demand has allowed mortgage rates to fall by 6% to 5% in the last month alone). At the same time, there are very few clues to suggest the economy is in trouble: swap spreads remain relatively low (i.e. liquidity is plentiful, contrary to what we would expect if the monetary policy was actually tight), and credit spreads are only moderately high (meaning the outlook for corporate earnings remains healthy) and, of course, job growth remains robust (the job creation in July was surprisingly strong). Either way, the debate over whether the economy is in a recession is irrelevant. If inflation slows, the Fed has no reason to raise rates until the economy collapses. If the bond market is right (and it usually is), then the Fed is likely to raise rates from 2.5% today to a high of perhaps 3.25% over the next few months. Next 6 months or so, and that’s just not the stuff of what recessions are made of.

Chart #1

ISM index of business activity in the service sector

Chart 1 shows that business activity in the all-important service sector of the economy (the source of around 75% of GDP) remains strong. Not booming, but well above levels that would be consistent with a recession.

Graph #2

ISM manufacturing prices paid

Since the vast majority of commodity prices have fallen significantly from their recent highs, a much smaller number of manufacturers now report paying higher prices (Chart 2).

Graph #3

Business credit spreads

Chart 3 shows the level of investment grade and high yield corporate debt spreads. It is the difference between yields on corporate bonds and the yield on Treasury bills of comparable maturity, an excellent indicator of corporate credit risk, itself strongly influenced by the economic outlook and corporate earnings. This is pretty good evidence that the economy is not in recession. (I’m not a fan of Biden, but he’s not crazy when he claims the economy isn’t in a recession.)

Graph #4

Unwanted spreads

Chart #4 is simply the difference between the two lines in Chart #3, which is commonly referred to as the “undesirable gap”. Today, junk bonds (corporate bonds rated below investment grade) are rated at a relatively modest level of risk to the economy. If we were in a typical recession, they would be considerably higher.

Graph #5

Jobs in the private sector or in the public sector

Chart #5 compares the number of jobs in the private and public sectors of the economy. Private sector jobs have now fully recovered to pre-Covid levels, but have yet to make any significant gains. Were it not for the Covid shutdowns, they would likely be at least 3-5 million higher. Public sector jobs, on the other hand, have not budged for more than a decade! This is progress in my book; private sector jobs are much more productive than public sector jobs.

Graph #6

US civilian workforce

Figure 6 shows the level of the civilian labor force – the part of the population that is of working age and ready to work. This is a prime example of failure to thrive. Today’s workforce is at least 18 million fewer than it might have been with different incentives. Slow growth in the number of people working or wanting to work translates directly into below-average growth for the economy as a whole (most small business owners continue to report that one of their biggest problems is not being able to fill vacancies).

Things could be better, but they could also be much worse.

Original post

Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

Comments are closed.