Unprecedented monetary and fiscal support in response to the pandemic has brought elevated inflation. Since March 2022, the Federal Reserve has been pursuing monetary tightening, resulting in the fastest pace of rate hikes in U.S. history, eleven separate increases bringing the federal funds rate to a range of 5.25%-5.5%. The Fed is attempting a soft landing for the economy, raising rates just enough to slow growth without causing a recession.
But what is the definition of a soft landing? In the past 75 years, every time the three-month moving average unemployment rate has increased 0.5% or more the economy has experienced recession (known as the Sahm Rule). In his March 2022 news conference, Fed Chairman Jerome Powell cited three times in history—1964, 1984, and 1994—that the Fed has been able to tighten monetary policy without increasing unemployment, successfully executing a soft landing. However, the only widely agreed-upon soft landing was engineered in 1994-1995 by then-Fed Chairman Alan Greenspan. Hard landings are much more likely, as in each of the years 1970, 1974, 1980, 1990, and 2008, when inflation was running higher than 5% Fed overtightening led to a recession.
The odds that the Fed might pull off a soft-landing this time around are increasing. Inflation as measured by the Consumer Price Index (CPI) registered 3.0% in June, down substantially from the peak of 9.1% one year ago. The drop in the price of oil resulted in a gallon of gas falling from over $5.00 last summer to $3.54 now. However, the contribution from falling energy and some food price decreases is set to fall out of the index next month as core CPI, excluding food and energy, rose at a still high 4.8% in June. The market has rallied on the belief that inflation is falling back to the Fed’s 2.0% target, but this enthusiasm might be short-lived.
Or maybe it won’t. We have discussed previously that much of the increase in core inflation can be explained by the shelter component of the CPI which makes up over one-third of the index. Housing costs moved up 7.8% in June, contributing over 70% of the increase in the CPI when excluding food and energy. Shelter costs are measured by “owners’ equivalent rent of residences”, an approximation of cost increases for homeowners, and “rent of primary residences”, reflecting rent increases. These measures increased 7.8% and 8.3%, respectively, in June. However, their calculation is subject to substantial smoothing that acts with a lag and is now overstating current housing inflation, likely dramatically.
As an example of how much the overstatement might mean for shelter costs, apartmentlist.com, a nationwide website of over five million apartments and rental properties, compiles the Apartment List National Rent Index (ALNRI), an indicator that strives to capture actual rental increases nationally. Its July report showed rent increases peaked in 2021 at 17.8%, just as the rental component of the CPI was heating up. In June 2023, the ALNRI was flat year over year, a sharp contrast to the 8.3% increase for the rental component of the CPI.
In further good news, the report goes on to explain that annual rental growth will likely turn negative in the months ahead as vacancies are high and new apartment supply is set to come online.
Progress on inflation doesn’t mean the Fed is out of the woods. Interest rate increases slow the economy with a lag, and the risk of overtightening given these lags is evident in the historical record.
Recent economic data looks strong. The Atlanta Fed estimates that GDP will grow 2.3% in the second quarter, a slight acceleration from the 2.0% rate of Q1. The employment market continues to chug along, with 209,000 jobs added in June and unemployment falling to 3.6%. Average hourly earnings grew 4.4% in June, matching previous gains in April and May and representing the first real wage gains since 2021.
Even so, the employment market is showing some cracks, as the number of people working part time because they cannot find full-time work jumped by nearly half a million in June. The labor force participation rate remains below the February 2020 pre-pandemic level of 63.3%. Initial applications for unemployment benefits, a proxy for layoffs, are up about 20% since the start of the year. At the start of recessions, the employment market can fall off quickly, and these cracks bear watching.
While financial markets have been volatile since the pandemic, equity investors in stocks who stayed fully invested have made money. As always, picking growing companies at reasonable valuations is eventually rewarded.
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