Wrangling Inflation in Jackson Hole

The Kansas City Federal Reserve will hold its annual Jackson Hole symposium this week where policymakers will discuss, “Reassessing Constraints on the Economy and Policy.” Fed officials will likely cover many topics, but there is only one that matters for financial markets, which is how far is the Federal Reserve willing to go to wrangle runaway inflation.

While headline consumer price index (CPI) inflation looks like it peaked in July, when energy prices are excluded, inflation has been running at 6.6% for four consecutive months (see figure 1). That is probably not the persistent decline that the Fed is looking for. Likewise, when officials look at the Atlanta Fed’s measures of flexible and sticky inflation, flexible inflation has come down with energy prices, but so-called sticky inflation continues to rise with the latest print coming in at 5.7% (see figure 2). When combined, we suspect it is too early for the Fed to declare victory on inflation. Particularly with financial conditions once again loosening with equity markets pushing higher since mid-June. 

This line chart shows the year-on-year percent change of the U.S. Consumer Price Index from January 2019 to July 2022.

This line chart shows Atlanta Fed’s Measures of Flexible Inflation and Sticky Inflation year-over-year percent change from 1970 to 2020.

The question then becomes whether the Fed should keep raising interest rates and risk tilting the economy into a recession in 2023 or should they slow down their pace of rate hikes and let the monetary policy already put in place work through the system and reassess as economic data roll in? Financial markets seem to think that the latter scenario is the most likely and are now betting that the Fed will cut rate in the back half of 2023. While a Fed pivot on rate hikes is currently being viewed as a positive for risk assets like stocks, we worry that the optimism may prove somewhat overdone if the Fed pivot signals concerns about the economic outlook.

Most economic data continue to point to an economy that is still expanding modestly with the Atlanta Fed’s GDPNow real-time estimate for 3Q 2022 tracking at 1.6%, but the Conference Board’s leading economic indicator index suggests a further slowing as monetary policy becomes restrictive. While the index has sent false recession signals in the past (1996, 1999, and 2016), a continued fall below zero on a year-on-year basis bears watching as it has tended to occur about 10 months before the onset of a recession (see figures 3-4). In our view, a recession in 2023 may still be in the cards if the Fed continues to tighten, which is why the Jackson Hole symposium and the September FOMC meeting take on even more importance than normal.

This line chart shows the U.S. Leading Economic Indicators Index vs. Periods of U.S. Recession from 1986 to 2021.

This line chart shows the U.S. Leading Economic Indicators vs. Real Gross Domestic Product year-over-year percent change from 1986 to 2021.

When it comes to this week’s meeting, we suspect that the Fed is going to take a hawkish tone, even if they don’t really mean it. It is sort of like threatening to take your child’s toy away to get them to behave (in this case the markets) even though you may not intend to follow through. With financial conditions loosening, the Fed may feel the need to tamp down market expectations to get the economic response that they want, which is a weakening in demand amid a healing in supply chains. That is the elixir that the Fed is hoping will cure inflation.

Importantly, a soft landing cannot be completely ruled out, but it may require the Fed to “hike and hold.” Meaning that a pause may be a prerequisite for the recent equity market rally to hold and for the economy to stabilize before the Fed can move forward with even more rate hikes. Thus far, Fed officials have not expressed much interest in that approach though. Currently, the dynamic seems to be more like flying a plane in turbulent air. Everyone is uncomfortable and knows that it will likely be a bumpy descent, but there is no choice but to land and simply hope for the best (be it a soft or hard landing).

This lack of clarity is why Citi Global Wealth Investments’ Global Investment Committee (GIC) has decided to remain cautious despite the solid rally since mid-June. We recommend that investors stay focused on both quality stocks (those with stable earnings and consistent dividend growth) and quality fixed income (like U.S. Treasuries). We did, however, recommend adding exposure to short-duration U.S. Treasuries and investment grade credit at our July meeting. We think that a 2-year U.S. Treasury yield of 3.3% (at the time of this writing) looks attractive for diversified portfolios. The GIC funded this by reducing its exposure to global natural resource stocks. While we still think there may be some upside heading into the fall and winter months, energy sector earnings-per-share (EPS) have averaged an 86% decline from peak-to-trough during the last four recessions. While we see the odds of a U.S. recession in 2023 evenly balanced at about 50% (the odds of a recession in any given year are typically about 15%), we think the downside risk for the energy sector might outweigh the potential upside.

What Should U.S. Investors Watch in the Week Ahead?

Aside from the Fed’s Jackson Hole meeting, investors will get fresh reads on new home sales and the personal consumption expenditure deflator, which is the Fed’s preferred inflation measure. Unsurprisingly, new home sales are expected to fall by 2.6% while PCE inflation is expected to dip from 6.8% in June to 6.4% in July.

Housing has probably been the most immediately impacted industry from Fed policy with mortgage rates shooting up very quickly and sitting around 5.7%. However, we do not think that this downturn in housing will be anywhere near as severe as during the Global Financial Crisis. Not only are household balance sheets much stronger and bank balance sheets more well-capitalized, but the housing stock is much lower than in 2007 and 2008 (see figure 5). National home prices may decline over the next year or so, but the low level of inventory may act to limit some of the downside.

This line chart shows the percent of U.S. Homeowner Vacancy Rate from 1956 t0 2026.

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Index	Weekly Chgchange in percent	YTDyear to date change in percent	12 Months12 month change in percent	Div. Yield division yield in percent
Dow Jones	-0.2%	-7.2%	-3.4%	2.0%
S&P 500	-1.2%	-11.3%	-4.0%	1.6%
NASDAQ	-2.6%	-18.8%	-12.6%	0.8%
Instrument	Weekly Chgchange	YTDyear to date	12 Months12 month change	Level
10-Year Treasury Yield (%)	14 bps	146.2 bps	172 bps	2.97%
Gold ($/Oz.)	-3.1%	-4.5%	-1.9%	$1,747.1
Oil ($/bbl)	-1.4%	17.9%	42.5%	$90.77

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This table shows returns for various USA equity markets and select assets, in weekly, year-to-date and 12 month changes.

Index	Weekly Chg change in percent	YTD year to date in percent	12 Months12 month change in percent	Div. Yield division yield in percent
Global	-1.6%	-14.3%	-10.2%	2.2%
Europe	-2.6%	-19.9%	-18.3%	3.4%
Japan	-1.4%	-16.4%	-15.7%	2.4%
Emerging Markets	-1.5%	-16.9%	-16.4%	3.2%

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This table shows the US Stock Market Returns and Select Assets and International Stock Market Returns.

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Date	Time	Event	Period	Consensus	Prior
8/23	10:00	New Home Sales	JulJuly	575k thousand	590k thousand
8/23	10:00	New Home Sales MoMMonth over Month	JulJuly	-2.5%	-8.1%
8/24	8:30	Durable Goods Orders	Jul PJuly	0.8%	2.0%
8/26	8:30	Advance Goods Trade Balance	JulJuly	-98.5b billion	-98.2b billion
8/26	8:30	Personal Income	JulJuly	0.6%	0.6%
8/26	8:30	Personal Spending	JulJuly	0.4%	1.1%
8/26	8:30	PCE personal consumption expenditures Deflator MoMMonth over Month	JulJuly	0.0%	1.0%
8/26	8:30	PCE personal consumption expenditures Deflator YoY year on year	JulJuly	6.4%	6.8%
8/26	8:30	PCE personal consumption expenditures Core Deflator MoMMonth over Month	JulJuly	0.2%	0.6%
8/26	8:30	PCE personal consumption expenditures Core Deflator YoY year on year	JulJuly	4.7%	4.8%
8/26	8:30	Retail Inventories MoMMonth over Month	JulJuly	1.3%	2.0%
8/26	10:00	U of Mich.University of Michigan Sentiment	AugAugust F	55.4	55.1

This table lists a number of key economic events, analysis reports and forecasts from influential institutions.

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