This Recession Won't Get The Fed To Back Off

Summary

  • The odds for a technical recession appear to be very high.
  • But a technical recession will not derail the Fed's mission to bring down inflation.
  • The Fed will need to get the inflation rate below the nominal GDP growth rate.
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FED federal reserve of USA sybol and sign.

Bet_Noire

Don't be surprised if the US is in a technical recession by the time July is over. The odds are high that second quarter GDP growth will be negative. The Atlanta Fed GDPNow model as of July 6 is at -2.1%. That would make for the second straight quarter of negative GDP growth. But that doesn't mean the Fed will back off.

The Fed can't back off because GDP is likely to be negative in the second quarter because of high inflation. GDP has a price index, which tends to track CPI pretty closely over time. Given that CPI is likely to be over 8% in the second quarter, there's a good chance the GDP price index will be around 8%, which makes it very difficult for a positive GDP result in the second quarter.

Headline GDP is adjusted for inflation and referred to as real GDP. But to get real GDP, it starts with nominal GDP and then is adjusted for the inflation rate. In this case, a -2% real GDP print, with an 8% inflation rate, would imply that nominal GDP is growing around 6%.

Of course, the scenario creates a big problem for the Fed and the markets. Because the markets appear to be following the normal recession playbook of the past two decades, falling commodity prices and inverting the yield curve making everyone believe the Fed will soon back off.

But this is where the idea of the Fed backing off may be completely wrong. The economy may go into a technical recession in real terms, but it may not go into recession in nominal terms.

This minor subtlety has a significant implication because it's possible for a string of negative real GDP prints over the next few quarters. If the Fed does what it plans to do, which is slow demand, then nominal GDP growth and inflation should come down. But the Fed must bring the inflation rate back below the nominal GDP growth rate to push the real GDP growth into positive territory.

Historically, when nominal GDP is above the inflation rate, the economy is healthy. When the inflation rate rises above nominal GDP, the US economy tends to fall into recession. But during those recessions, nominal GDP and inflation rates tended to approach 0% slowly. It was only during the 2008 recession and the coronavirus recession that nominal GDP went profoundly negative.

The data also shows that the recessions of the 1970s and early 1980s tended to be long lasting. Certainly more so than the 1990 recession, 2000 recession, and coronavirus recession. It supports the idea that if there's a recession in 2022 and 2023, it will probably look more like the 1970s and 80s, and less like the ones witnessed in recent times. Inflation and growth rates today resemble those of the 1970s and 1980s.

Chart

Bloomberg

This is why the Fed is not likely to back off raising rates and keeping financial conditions tight just because there is a quarter or two of negative real GDP prints. It might be that there will need to be a few quarters of negative real GDP prints to bring the inflation rate back to the Fed's mandated average 2% target.

chart

Bloomberg

If the Fed cannot bring the inflation rate down soon, then rates will have to go much higher. Historically, the 3-month Treasury bill has traded with a higher rate than the year-over-year CPI inflation rate. It has only been over the past decade that the inflation rate has run hotter than the 3-month Treasury bill rate. This would indicate that for inflation to start coming down again, the Fed would need to raise rates further to bring up the 3-month Treasury bill rate.

High inflation creates a new set of dynamics that markets haven't dealt with for a very long time and means that investors need to change their thought process to just how and when the Fed may blink. It may not come nearly as quickly as many believe and may require much more pain before resolving the issue.

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Designed for investors looking for stock ideas and broader market trends.

I am Michael Kramer, the founder of Mott Capital Management and creator of Reading The Markets, an SA Marketplace service. I focus on macro themes and trends, look for long-term thematic growth investments, and use options data to find unusual activity.

I use my over 25 years of experience as a buy-side trader, analyst, and portfolio manager, to explain the twists and turns of the stock market and where it may be heading next. Additionally, I use data from top vendors to formulate my analysis, including sell-side analyst estimates and research, newsfeeds, in-depth options data, and gamma levels. 

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Charts used with the permission of Bloomberg Finance L.P. This report contains independent commentary to be used for informational and educational purposes only. Michael Kramer is a member and investment adviser representative with Mott Capital Management. Mr. Kramer is not affiliated with this company and does not serve on the board of any related company that issued this stock. All opinions and analyses presented by Michael Kramer in this analysis or market report are solely Michael Kramer's views. Readers should not treat any opinion, viewpoint, or prediction expressed by Michael Kramer as a specific solicitation or recommendation to buy or sell a particular security or follow a particular strategy. Michael Kramer's analyses are based upon information and independent research that he considers reliable, but neither Michael Kramer nor Mott Capital Management guarantees its completeness or accuracy, and it should not be relied upon as such. Michael Kramer is not under any obligation to update or correct any information presented in his analyses. Mr. Kramer's statements, guidance, and opinions are subject to change without notice. Past performance is not indicative of future results. Neither Michael Kramer nor Mott Capital Management guarantees any specific outcome or profit. You should be aware of the real risk of loss in following any strategy or investment commentary presented in this analysis. Strategies or investments discussed may fluctuate in price or value. Investments or strategies mentioned in this analysis may not be suitable for you. This material does not consider your particular investment objectives, financial situation, or needs and is not intended as a recommendation appropriate for you. You must make an independent decision regarding investments or strategies in this analysis. Before acting on information in this analysis, you should consider whether it is suitable for your circumstances and strongly consider seeking advice from your own financial or investment adviser to determine the suitability of any investment.

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