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Opinion: Economic factors to watch: inflation, interest, illiquidity

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The 1986 movie “Three Amigos!” is about three movie stars desperately struggling to remain in the limelight. In today’s economy, the variables in the limelight are what I’m calling the three “I”migos: inflation, interest rates and illiquidity. 

 

Inflation 

There is no hiding from it; inflation has affected businesses and consumers. Beginning in early 2021, the consumer price index has materially spiked higher, moving from less than 2% to more than 8%. This occurred due to the unprecedented response to the global pandemic. Massive liquidity infusions increased demand while shutdowns curbed supply. 

The constant debate today is how much inflation will be transitory, if any. Inflation has been broad based, from commodities in the energy and agricultural space, to shipping rates and wages, housing and transportation – all have been drivers in spiking inflation. 

Academic studies suggest optimal core inflation, excluding food and energy, is around 2%-3%. In April, core CPI hit 6.2%, giving consumers, businesses and the Federal Reserve some heartburn. Some inflation is good for economic activity. With moderate inflation, businesses can increase prices and provide higher wages while still growing earnings that drive equity prices higher. Spiking and uncontrollable inflation crushes demand and earnings, a bad combination for the economy and for financial markets. 

As always, there are some businesses that may benefit from higher inflation. If a company has pricing power and can pass along higher costs to the consumer, higher inflation may not be as damaging. The industries with pricing power today include energy, chemicals, steel, fertilizer, trucking and building materials. Industries that are experiencing the weakest pricing power include internet, broadcasting, pharmaceuticals and financial companies. 

We think some of the primary inflationary variables will be transitory. As supply chain and labor force issues abate, inflation should slowly head lower. 

 

Interest rates 

The Fed is in the middle of an experiment, letting the economy run hot and allowing inflation to build, hoping to control inflation after it has already spiked higher. Will it work? We are still in the experiment. The Fed’s narrative has been fluid over the past year; however, today it appears the Fed has an aggressive plan for hiking interest rates. 

Perhaps due to the experiment, the aggressive path is unusual with limited historical data. We expect the Fed to increase the federal funds rate another 175 basis points by year-end, ending 2022 at 2.75%.   

A comparable rate hiking cycle may be from 1994-95. The Fed hiked rates by 300 basis points over a 12-month period, including 50 and 75 basis points hikes. The expected path of Fed funds for the remainder of the year appears to be quite similar. If the financial markets behave as they did in 1994-95, longer-term yields will continue to rise until rate hikes are ending. Risk-based assets, such as stocks, may not perform well during the rate hiking cycle but could skyrocket higher as the cycle ends. In early 1994, the Fed started to increase rates and increases continued throughout the year. In 1994, the S&P 500 posted a 1.7% rate of return. The rate hiking cycle ended in early 1995. That year the S&P 500 gained a hefty 37.5%. If history is close to repeating itself, rates will increase, squashing inflation, and economic activity will slow, but just like 1994-95, our economy may avoid a recession. 

 

Illiquidity 

Banks, credit and liquidity are the lifeblood of the economy. Given the government’s $5 trillion injection of cash into our economy during the COVID-19-inspired recession, money supply growth soared at the highest rate in our history with 26% annual growth in early 2021. Almost a year after the cash injections, aggregate cash reserves continue to build, currently sitting at a record $21.9 trillion. Consumer demand for goods and services continues to mushroom, even as stimulus is reduced.   

Liquidity was a significant driver of growth. The pressing question is what will happen when liquidity is taken out of the economy? As the growth of money supply subsides and demand remains firm, overall liquidity will slowly erode. While we are a long way from any type of potential illiquidity, current trends are moving in the direction of steadily reduced liquidity within our system. If this situation persists, lower liquidity could become a growing issue in the years ahead, slowing economic activity. Liquidity reached record levels not so long ago, and the trend could only go in one direction: lower. It remains to be seen how long and far this trend will run. Nevertheless, the combination of higher interest rates and the potential of illiquidity is a recipe for slower gross domestic product growth in the U.S. 

 

Recession potential 

An increase in rates doesn’t imply a looming recession. In 1995, after a 300-basis point increase, the economy avoided a recession and equity markets performed well. Our economy has experienced rising rate cycles without falling into recession at multiple times in history. The key issue is whether the current inflation spike manages to naturally move lower, with some help from higher interest rates. 

If the inflation figures begin to move lower, as we think they will, then we have a reasonable chance of working through this cycle of rising rates without experiencing a recession. But if inflation proves stubborn, requiring more aggressive action from the Fed, then the likelihood of a recession will begin to rise. 

At this time, we think GDP growth in 2022 will be approximately 2.4%. The odds of a recession occurring in late 2023 are increasing. 

The three “I”migos will give us clues on how these odds are changing. 

 

KC Mathews is the chief investment officer for UMB Bank in Kansas City. 

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