Bird of prey

Bottom Line 

Despite the Federal Reserve’s swift withdrawal of monetary policy accommodation over the past seven months, inflation is still regrettably rising. Core CPI leapt from 6.3% year-over-year (y/y) in August 2022 to a new 40-year high of 6.6% in September 2022, and the 1-year inflation expectation of October’s University of Michigan Consumer Sentiment Index surged from 4.7% to 5.1%. September’s core PCE inflation is expected to rise from 4.9% to 5.2% y/y. Elevated wages are sticky, record-high shelter costs seem sustainable and energy costs likely will surge heading into winter. 

As a result, Federal Reserve tightening has not yet peaked, and the Fed will likely continue to raise interest rates aggressively to combat inflation. We expect the fourth consecutive 75 basis-point hike at its Nov. 2 policy-setting meeting, with perhaps a half-point hike at the following one on Dec. 14. The fed funds rate could peak at 5% or higher early next year. Simultaneously, the Fed is shrinking its bloated $9 trillion balance sheet at a lively pace of $95 billion monthly ($60 billion in Treasuries and $35 billion in mortgage-backed securities). The plan is to pare its holdings by a third over the next three years, which would effectively add another quarter-point rate hike each year.

As the Fed executes its Phillips Curve trade-off, we expect to see a gradual reduction in inflation over the next two years. But the price is higher unemployment—perhaps double the current half-century low of 3.5%—and much slower economic growth, with the growing risk that the economy is on a glide path into recession in 2023.

It’s not all doom and gloom The labor market remains relatively healthy as measured by the unemployment rate. But we’re starting to see some cracks, with weakening metrics in household employment, ADP private payrolls, the JOLTS report, Challenger job cuts and weekly claims.

Important Back-to-School (BTS) 2022 sales (from June through September, inclusive) rose a healthy 9.1% y/y, but that pace is roughly half the outsized 16.4% gain registered during BTS 2021 (they rose an average of 3.7% the previous five years.) Because these sales are highly correlated (80-90%) with Christmas spending, it appears that holiday sales this year might rise by a solid, but sequentially slowing 7-9%, down from 16.3% in 2021. 

Housing and manufacturing slowing The housing market has slowed sharply this year as mortgage rates have more than doubled from 3% to 7%. The Housing Market Index (HMI) rose to a 10-month high of 84 in December 2021, but it has since plummeted for 10 consecutive months to a much weaker-than-expected 2-year low of 38 in October 2022. Manufacturing activity has similarly begun to decelerate, as the six regional Federal Reserve manufacturing indexes we monitor have all declined sharply over the past six months.

LEI’s negative Although business and consumer confidence have improved in recent months, the Leading Economic Indicators index (LEI) has declined six months in a row and seven times in the past eight months through August, which suggests a recession is brewing. It had hit a 61-year cycle high in February.

Financial markets are pricing in higher interest rates and slower economic growth Benchmark 10-year Treasury yields surged to an oversold 15-year high at 4.33% today, and the 2/10 yield-curve inversion suggests that the bond market is pricing in the elevated risk of recession. Stocks have officially retraced half of their 120% gains from 2020-21, falling by more than 27% so far this year to an oversold 3,492, and we may not be done yet. 

Reducing our GDP estimates for 2023 The liquidity, equity, and fixed-income investment professionals who comprise Federated Hermes’ macroeconomic policy committee met Wednesday to discuss still elevated inflation, the hawkish Fed and the resulting deceleration we expect in economic growth: 

• Third quarter GDP growth in 2022 will be flashed on Oct. 27. Despite the Fed’s 75-basis-point hikes in each of July and September, BTS spending was still relatively strong, up 9.1% y/y. So we raised our third quarter estimate from 0.6% to 1.4%. The Blue Chip consensus inched its estimate up from 1.2% to 1.3% (in a range of -0.1% to 2.5%) versus a decline of -0.6% in the second quarter. The Bloomberg consensus is at 2.3%, and the Atlanta Fed’s GDPNow model is at 2.9%, up from 1.3% last month. 
• We expect the Fed to add another 75-basis point hike on Nov. 2, and Dec. 14 could be a half-point increase or higher, depending on inflation. So much like BTS, Christmas spending could slow to half of last year’s strong season, but at a relatively healthy pace. We left our GDP estimate unchanged in the fourth quarter of 2022 at 0.1%. The Blue Chip consensus cut its estimate from 0.9% to 0.2% (in a range of -1.5% to 1.4%).
• We inched our full-year 2022 GDP estimate up from 1.5% to 1.6%. The Blue Chip also increased its forecast from 1.5% to 1.6% (within a range of 1.1% to 1.9%). 
• We increased our full-year 2022 forecast for core CPI inflation from 5.4% to 5.7% (compared with an actual 40-year high of 6.6% in September 2022), and we increased our full-year 2022 forecast for core PCE inflation from 4.8% to 5% (compared with an actual 4.9% in August 2022).
• We left unchanged our first quarter of 2023 GDP estimate at -0.7%. The Blue Chip consensus gutted its estimate from 0.6% to -0.2% (within a range of -1.9% to 1.4%).
• We reduced our second quarter of 2023 GDP estimate from -0.9% to -1.2%. The Blue Chip consensus reduced its estimate from 0.7% to -0.1% (within a range of -1.8% to 1.6%).
• We sharply reduced our third quarter of 2023 GDP estimate from 0.5% to -0.6%. The Blue Chip consensus lowered its estimate from 1.1% to 0.7% (within a range of -1.1% to 2.3%).
• We also reduced our fourth quarter of 2023 GDP estimate from 0.5% to -0.6%. The Blue Chip consensus cut its estimate from 1.6% to 1.3% (within a range of 0% to 2.7%).
• As a result of those downward quarterly cuts, we reduced our full-year 2023 GDP estimate from -0.2% to -0.4%. The Blue Chip consensus cut its estimate from 0.7% to 0.2% (within a range of -1.1% to 1.4%).
• We increased our full-year 2023 forecast for core CPI inflation from 3.9% to 4.1% and for core PCE inflation from 3.3% to 3.6%.

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