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It is a combination of multiple negative factors that creates a worrisome diagnosis for already fragile economic health of the US economy. A sharp increase in oil prices from $22 in April 2020 to $120 in June 2022. The highest inflation since 1981 which is likely to stay elevated for a while. The Fed which found itself behind in raising rates and has a catch up to do to preserve its credibility. The US consumers who are experiencing a decline in real wages, increase in debt, and a decline in savings. About 70% of the Gross Domestic Product is explained by the consumer spending. With falling disposable income, the GDP is likely to decline as well. All these negative factors combined create a possible case scenario for the economic recession in the near term. This economic recession may be caused by a sharp decline in consumer spending which will also lessen inflationary pressures.
Today’s oil price is at $120 up from just $22 in 2020. Nonlinear models of using net oil price increase to explain the US recessions may explain as high as 5 percent decline in the US real GDP according to Kilian and Vigfusson (2014). The conditional regression model becomes even more effective when combined with a restrictive monetary policies and high inflation during Paul Volcker time and the global financial crisis of 2008 according to Kilian and Vigfusson (2014).
The recession does not always follow the increase in oil prices. Since 1974 there were eight episodes of net oil price increases and only five were followed by recessions based on Kilian and Vigfusson (2014). There is also no exact timing for predicting a recession. Some recessions happened few months after the increase in net oil price. Other recessions happened at the same time of the increase in oil prices (see Chart 1). On its own the increase in oil prices may not be the sole cause of a recession. However, when we start adding extra negative economic forces, the risk for a recession may increase significantly.
Current inflation in the US has increased the most since the 1981 based on the Consumer Price Index. This index increased by 8.6% for the 12 months ending May 2022 according to the U.S. Bureau of Labor Statistics. Some items saw the record price increases. Fuel oil more than doubled in price over the last 12 months, rising 106.7% (see Chart 2). It was the largest increase in the history of the series, since 1935, according to the U.S. Bureau of Labor Statistics. Food at home also saw a record increase by 11.9% over the last 12 months. It was the largest increase since 1979. Inflating is proving to be more sticky than transitory. Prolonged war in Ukraine with no near horizon solution is likely to keep a supply driven inflation high for commodities and agricultural products for a while. I have also described a supply driven inflation in my prior article as of March 2022. You can read my full article by clicking on this link: https://ecnfin.com/2022/03/21/economic-recession-maybe-around-the-corner-in-the-us-and-europe/
Russia is a major supplier of nickel, major exporter of oil, natural gas, coal and the world’s biggest exporter of wheat and fertilizer products. Ukraine is also one of the biggest exporters of wheat and agricultural products. Since the US oil production does not increase and the supply disruption of other commodities and agricultural products are likely to be long-term, the inflationary pressure may persist.
The Federal Reserve has a dual mandate: low and stable inflation at the rate of two percent and maximum employment level according the Bord of Governors of the Federal Reserve System (2022). The current unemployment rate is at 3.6% (see Chart 3). The 3.6% unemployment rate is one of the lowest numbers since 1970s and gives the Fed plenty of room to raise rates. The Fed has its reputation to safeguard and a dual mandate to focus on. To fight the inflation, the Fed will need to orchestrate economic slowdown and increase unemployment. As you can see from the Chart 3, unemployment increased during all economic recessions. The Fed will try do its best to do a soft landing – slow down the economy without causing a recession. However, soft landing would be very difficult to do given the Fed is already behind the curve and is facing a continuous increase in inflation. You may think of the current Fed as a student with all C grades during the semester who is now trying to pull an A grade during the final exam. It is statistically possible but highly unlikely. Adding an additional analogy of the Federal Government as a parent who did not invest time and money into the education system and instead gave one-time gifts to the student. Both the student and the parent will have a very difficult and painful time trying to change. The student may still be able to pass the class but receiving an A grade looks very unlikely.
The Fed has couple of tools in its possession to slowdown the economy. The first and the most used tool is the target interest rate set by the Federal Open Market Committee. This rate is also called the federal funds rate. On May 4th, 2022, the Fed increased its target range for the federal funds rate to 0.75%-1% according to the Federal Reserve (May 4, 2022). The Fed is expected to continue interest rate increases as inflation persists.
The second tool is the Fed’s balance sheet. By reducing the holdings of securities on its balance sheet, the Fed will decrease the amount of money available in the system. The current Fed’s balance sheet has about $8.5 trillion worth of securities held according to the Federal Reserve (June 9, 2022). The Fed holds the US treasury securities of different maturities from short-term to long-term (see Chart 4). According to the Federal Reserve, it will reduce its balance sheet by not reinvesting the proceeds from the principal and interest payments received. For the US treasuries the decline in holdings will be in the amount of $30 billion per month from June 1, 2022 and $60 billion per month after September 1st, 2022. For the agency debt and mortgage-backed securities the decline will be $17.5 billion per month from June 1, 2022, and $35 billion per month after September 1st, 2022. By looking at the maturity distribution of the current balance sheet you may notice that the Fed has enough US treasury bonds maturing on time to meet the scheduled reductions by the Fed. So, the Fed will keep the money received from maturing debt principle without buying or selling additional US treasury securities. In contrast, mortgage debt securities held by the Fed have much longer maturity schedule. So, the Fed may have to sell mortgage-backed securities.
The current main goal of the Fed is to slow down the demand-pull inflationary pressures. By raising its interest rate and shrinking its balance sheet, the Fed is trying to slowdown the consumers’ demand. Consumer spending accounts for about 70% of the Gross Domestic Product in the US. Even before the Fed’s more restrictive monetary policies, some consumers were already feeling priced out. The increase in wages does not fully compensate for the increase in the inflation. As the result, consumers now have less purchasing power than before. For example, the real weekly earnings declined from $393 during the 2nd quarter 2020 to $363 during the 4th quarter 2021 (see Chart 5). This represents the 8% decline is the real purchasing power.
The decline in the personal savings rate also supports the view that the US consumer is already feeling financially stretched. The personal savings rate has already declined to 4.4% which is the lowest level since the global financial crisis of 2007-2008 (See Chart 6). The Fed just started raising rates, and the inflation is likely to stay elevated much longer. With rising interest rates and elevated inflation, there is no relief for the consumer in the near term.
Consumers’ debt levels on credit cards and other revolving plans have increased to the new historical record level. As of June 2022, the consumer loans balance was $868 billion (see Chart 7). Consumer credit card loan payments increase with the increase in interest rates. As rates increase, consumers’ interest expense may increase further causing a further decline in the disposable income.
Similarly, corporations have also increased its debt levels to the historical record. As of June 2022, non-financial corporations borrowed $12,169 billion (see Chart 8). High debt levels help during the good times and hurt during the bad times. A possible economic recession may decrease corporate revenues caused further decline in profitability of a more leveraged companies. The decrease in corporate profits may also hinder the ability of companies to meet its debt obligations.
Combination of the above-described factors: high oil prices, persistent inflation, high consumers’ and corporate debt balances, and restrictive monetary policies create a case scenario for a possible economic recession. One possible outcome from this recession can be a decline in consumer and business spending, which will increase unemployment and decrease the demand for goods and services. If this scenario plays out, the inflationary pressures will fade at the cost of the recession.
The analysis is based on historical data and future expectations that may not be correct. This paper was written as an opinion only. The data is not guaranteed to be accurate or complete. Please consult with your financial advisor, before making an investment decision. Neither ECNFIN.COM nor its author are responsible for any damages or losses arising from any use of this information. Past performance doesn’t guarantee future results.
ECNFIN.com and its podcast are not associated with nor do they necessarily represent the opinion or advice of Epiqwest Culver Wealth Advisors LLC.
Bord of Governors of the Federal Reserve System 2022. https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm
Board of Governors of the Federal Reserve System (US), Consumer Loans: Credit Cards and Other Revolving Plans, All Commercial Banks [CCLACBW027SBOG], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CCLACBW027SBOG, June 11, 2022.
Board of Governors of the Federal Reserve System (US), Nonfinancial Corporate Business; Debt Securities and Loans; Liability, Level [BCNSDODNS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BCNSDODNS, June 12, 2022.
Federal Reserve statistical release June 9, 2022. https://www.federalreserve.gov/releases/h41/current/h41.pdf
Federal Reserve issues FOMC statement, May 4, 2022. https://www.federalreserve.gov/newsevents/pressreleases/monetary20220504a.htm
Lutz Kilian and Robert J. Vigfusson “The Role of Oil Price Shocks in Causing U.S. Recessions” Board of Governors of the Federal Reserve System August 2014 https://www.federalreserve.gov/pubs/ifdp/2014/1114/ifdp1114.pdf
Macrotrends data retrieved on June 12, 2022. https://www.macrotrends.net/1369/crude-oil-price-history-chart
Plans for Reducing the Size of the Federal Reserve’s Balance Sheet. May 4, 2022. https://www.federalreserve.gov/newsevents/pressreleases/monetary20220504b.htm
U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UNRATE, June 12, 2022.
U.S. Bureau of Labor Statistics, Employed full time: Median usual weekly real earnings: Wage and salary workers: 16 years and over [LES1252881600Q], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/LES1252881600Q, June 12, 2022.
U.S. Bureau of Economic Analysis, Personal Saving Rate [PSAVERT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PSAVERT, June 12, 2022.
U.S. Bureau of Labor Statistics. Consumer Price Index Summary. June 10, 2022. https://www.bls.gov/news.release/cpi.nr0.htm
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