The two dominant themes running through the U.S. economy in 2022 have been sluggish GDP growth and elevated inflation. From the growth perspective, this year has been the tale of two halves with the first two quarters seeing negative results for GDP followed by a positive third quarter and what is anticipated to be a continuation of upside growth in the fourth quarter.
On the inflation front we are seeing levels not experienced for decades with the Consumer Price Index hitting a 2022 year-over-year peak of 9.1% in June. This increase represented the highest 12 month increase in over 40 years. Another key theme for 2022 that is directly related to the rise in inflation has been the implementation of tighter monetary policy by the Federal Reserve (Fed). To date, the Fed, as a key part if its effort to drive the rate of inflation lower, has increased its Fed Funds short term interest rate from a range of 0.00 – 0.25% to the current level of 4.25 – 4.50%. In addition to interest rate increases the Fed is in the process of shrinking its balance sheet by not reinvesting proceeds from maturing bonds held in their portfolio. This tactic also puts upward pressure on interest rates by removing a significant buyer from the market which leads other participants to demand higher interest yields.
In the face of rising rates and divergent levels of growth there is a key metric that has demonstrated a high level of consistency this year and that metric is the rate of unemployment. With a high of 4.0% registered in January and a low of 3.5% seen in July and again in September, this measure of economic health has remained stable and currently sits at 3.7%. In fact, the consistency demonstrated by the labor market has been a factor in helping the economy stay out of recession in 2022. When consumers have jobs, they have the means to purchase goods and services. And those purchases account for approximately two-thirds of U.S. GDP.
With this somewhat somber backdrop of slow growth and elevated inflation we present our thoughts on the economic outlook going forward. As depicted in the below graph, expectations are for the rate of inflation to continue the moderation it has demonstrated over the past few months and economic growth to deliver sluggish results over the course of 2023. The restrictive monetary policy being pursued by the Fed is the primary factor behind this outlook as the higher level of interest rates resulting from this policy is weighing on the economy while also contributing to a moderation in the rate of inflation.
While the rate of inflation remains at an elevated level compared to pre-pandemic levels it has moved lower. Outside of monetary policy there have been several other contributors to the easing realized over the past few months. Oil prices have fallen from their peak seen several months ago, declining 12.7% over the past three months. Natural gas has experienced an even steeper three-month decline falling 26.5%. Several agricultural commodities have also seen prices move lower. Another factor contributing to the moderating rate of inflation is the decline in the growth of money supply depicted in the graph below. This graph shows the significant increase in M2 money supply which occurred during the coronavirus pandemic and prompted the rise in inflation that ensued, albeit with a lag. The increase in money supply was fueled by massive injections attributed to numerous government programs to help offset the economic damage inflicted during that period. M2 has been declining sharply since early 2021 and the lag between the two series should lead to further declines in the rate of inflation during 2023.
With the Fed’s tightening monetary policy exerting downward pressure on the economy there continues to be offsetting forces helping to keep it on the plus side. The previously mentioned stability on the labor front and positive momentum in capital expenditures are providing a tailwind in opposition to the Fed policy headwind. Ultimately the level of economic growth we will see will be highly dependent on how the rate of inflation moves going forward and how aggressively the Fed feels it has to respond to those movements.
In conclusion we reiterate our expectation of an economy walking a fine line which produces marginally positive growth with a very thin margin for error while experiencing a continued moderation in the rate of inflation. To this outlook we will add a standard qualifier of prospective impact to the outlook caused by negative developments on the geopolitical front or an unanticipated resurgence of the coronavirus. As always, we will be continually monitoring data and developments to help ascertain the prospective need for adjustments to our outlook.
Source: BTC Capital Management, Bloomberg LP, FactSet, Refinitiv (an LSEG company).
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