Elevated inflation, bank failures in tug-of-war over Fed policy

Highlights from the Monthly Review for May 2023:

Signs of decelerating economic growth in response to sharp Fed tightening suggest that the U.S. economy is in a pre-recessionary period. Key leading indicators including the yield curve and the Index of Leading Economic Indicators point to elevated recession risks over the next year. But the lead up to the next recession may linger due to continued solid hiring trends.

Key Takeaways: 

Economic Review: Labor market keeping the expansion afloat

Job and income gains remained buoyant through April, which should sustain some momentum for consumer spending. But businesses are pulling the reins on expenses and inventories, trends that typically result in a cooler labor market down the road. While the expansion continues for now, the conditions for the next economic downturn continue to take shape. (pg. 2)

Financial Markets: Markets remain caught in the middle

The crosscurrents of additional bank failures and better-than-feared corporate earnings kept the market within a tight trading range in April. Better-than-expected profits gave equities new optimism even though the earnings recession should persist. Still, the Treasury market felt the sting of further tremors from regional banks and fear of a US government default on its debt as the “X” date for breaching the debt ceiling approaches quickly. (pg. 3)

The Outlook: Is a long Fed pause forthcoming?

Financial markets expect the Fed to stop tightening rates in June and to pivot to rate cuts within a few months. This would generally be in line with history as the Fed has held rates steady after tightening cycles for only an average of 5.5 months over the past 50 years, with several shorter periods. Typically, stresses on the financial system, as evidenced by the recent regional bank failures, prompt the Fed to lower interest rates to cushion the downside impact on the economy especially as it moves into recession.

However, persistently high inflation is an important distinction in the current cycle, which is likely to keep the Fed from easing rates this year. Since the volatile double-dip recession of the early 1980s, inflationary pressures have been relatively muted in late cycle periods, allowing the Fed to react quickly to signs of deterioration within the consumer and business sectors. While the banking sector remains a downside risk, economic and inflationary conditions on balance suggest a longer-than-average wait for monetary policy easing.