2022 Economic Halftime Report: Has inflation hit its peak?
Tony Roth, Chief Investment Officer, Wilmington Trust Investment Advisors
Luke Tilley, Chief Economist, Wilmington Trust Investment Advisors
TONY ROTH: This is Tony Roth, Chief Investment Officer at Wilmington Trust and you are listening to Capital Considerations. We’re about halfway through the year, slightly over halfway, and we’ve had a first half of the year which really has left us a bit in shock, frankly. We came into the year thinking that we’d have a really strong economic year, probably GDP of a, maybe a bit shy of 4% on a real basis for the year, and we’ve gotten a very different story.
So, we need to take stock and we need to think about what the rest of the year is going to look like. And we’re going to do it today with our Chief Economist, Luke Tilley. And Luke is a member of our investment committee. I’m sure you’ve heard Luke on previous episodes of Capital Considerations, as well as his frequent appearances on FOX Business and CNBC. Prior to joining Wilmington Trust Luke worked as an Officer and Economic Advisor at the Federal Reserve Bank of Philadelphia, as a Senior Economist prior to that at ISH Markit, and as an Economist for the US Department of Housing and Urban Development. So again, Luke, great to see you.
LUKE TILLEY: Great to be back.
TONY ROTH: So, Luke, I started by saying how crazy and unexpected the first half of the year was. We probably had pretty much flat GDP in the first half of the year, a record tight labor market, and a whole slew of geopolitical surprises, partly related to COVID and the lockdowns in China, that have continued to impact the supply chain in frankly unexpected ways, and probably even more vital than that in understanding the economy, the war in Ukraine and its impact on things like energy, food globally, and consequently the very high readings we’ve been getting on headline inflation, even over core inflation. So, when you think about the first half of the year and what the most important factors have been as we sort of set the foundation for our conversation around what’s going to happen in the second half of the year, what should we focus on in your mind?
LUKE TILLEY: I think that there are at least two buckets to think about and one is just an unanticipated amount of weakness, either from the consumer or firms, that was going to happen probably a little bit too optimistic at the beginning of the year no matter what happened with the Fed with inflation. And then, the second bucket is definitely because inflation surprised to the upside and sort of the actions that the Fed has taken, which is actively cutting down on the GDP forecast. So, on the first one we’ve clearly seen a lot of what we anticipated at beginning of the year. We started off the year, our annual outlook was talking about how consumers were going to shift from purchases of goods to services, you know, leaving, being able to get out. We’ve got vaccines and a whole new life in the reopening of the economy and buying less goods and more over to services. And we have definitely seen that. And sort of the thing that may have been underestimated would be just the degree to which the cutback on purchases of goods and how much that has fallen. And what we’ve seen is not just a decrease in purchases, but it turns out a lot of retailers had over-ordered so now they’re cutting back on some of those orders. They’ve got an inventory bill that now they need to clear out. And those are the kind of things that go into that first bucket.
And then on the second side, which is obviously ongoing and what we need to focus on so much, is that inflation relative to the end of last year/the beginning of this year, just how much it has risen, especially on the services side, just how broad it’s been across categories. And that has the Fed doing what they have done, which is to get increasingly more hawkish, much more since the beginning of the year, and that is already having some real impact. Some of the negative numbers that you cited, Tony, and some of the concerns about going forward in the year are coming directly from those tightening of financial conditions that they’ve engineered. A good example is residential housing and home building, which has really come to a halt and really declined on a lot of measures in the face of the increases in mortgage rates and that’s coming directly from those Fed impacts in the second bucket, Tony.
TONY ROTH: So, okay, Luke. You talked about a little bit too optimistic at the beginning of the year. And I’m going to tease you a little bit, because sometimes I feel like optimism is an occupational hazard for economists. But I know that even though growth has been flat for the first half of the year on a real basis, you’re still optimistic that for the year we could get to 2% real growth, which would mean that basic math would tell us that we’ve got to reach 4% real growth in the second half of the year.
So, if inflation is running at the better part of 8% and headline, right, so including food and energy increases, and you think that maybe 4% growth, if my math is correct, real, that means that nominal growth is going to have to get to 12% or inflation’s really going to have to decelerate quickly moving forward in order to get to that number. So, do I have, have I characterized your thoughts fairly on what your forecast is? And, if so, how do you get there?
LUKE TILLEY: Yeah. So, it’s 2% growth for the year is the expectation and acknowledging that we do have this big negative to start the year, the -1.6% with GDP to start the year. On the nominal and the inflation adjustment, no, I don’t think we’re going to have 8% inflation over the course of this year. We do think it’s going to decelerate down to, using the CPI, about 5.5% at the end of this year.
But I think the most important part here as we think about it is just how strong the domestic numbers still are. So, I did say that consumers had shifted away from goods more than we expected. Overall consumer spending is still pretty strong. It was even strong in that first quarter, contributing to growth. And our domestic businesses and capex was really strong.
What really pulled down on the first quarter was the international picture. Our domestic consumers were spending so much that our imports were really high and that’s a subtraction from GDP. And our exports were incredibly weak, especially to Europe and actually some emerging markets too, and that was the drag on GDP.
So, the optimism about growth is even though it’s come in a little bit weaker for some items is that we’re going to still have that strong domestic growth. But if it misses to the downside of that 2%, it’s most likely going to be because of weaker international activity, those weaker exports and the weakness that we’ve already seen in inventory builds, but not because of a reversal or a slowdown. If the non-recession call holds up, that’s where it would be, Tony.
TONY ROTH: So, Luke, when you think about inflation coming down to, you know, 5-5.5% by the end of the year, when I look at core inflation, which is basically everything but food and energy you do see the data suggesting that inflation’s coming down. You know, we’ve sort of reached that peak. When you look at headline inflation, I don’t think we see that necessarily. And headline inflation is ultimately what matters in that when we look at real GDP, we have to look at all inflation and subtract that from nominal growth and that’s how you get to real GDP.
So, when we think about the markets as investors, what’s it going to take to see the market start to recover? We have to see, number one, we have to be able to identify a peak in inflation. Secondly, we need to be able to see that we’re going to come off of that peak with enough rapidity, enough weakness in inflation to be confident that the inflation problem is sort of in the rearview mirror even though it’s going to take a while to come back down to the Fed’s neutral rate, maybe even a few years, but that would really get the market set up for strength.
So, when you think about that headline number, what are you looking at to give you confidence that we are going to form a peak relatively soon and that our total inflation number will come down? Particularly given the problems that we see in the war in Europe and the fact that so much of that headline inflation, energy and food problems, seem to be emanating from that one specific conflict which seems to just be ongoing.
LUKE TILLEY: I think that that’s the key risk really is the things that are emanating from that conflict, particularly on the energy and food side, as you said. So, just to put some numbers to it, the CPI measure of inflation hitting 8.6% in May and that was establishing a new peak, as you said, when we thought it had peaked. Core inflation did continue to move down, down to now like 6% from what had been 6.5%. So, it’s already down 0.5% from March. But as you said, it’s overall inflation that really matters.
And I think the biggest driver here is how much consumers are willing and able to take on price increases across goods, because if you think about what has happened over the course of the past year and why inflation moved so high, these price increases can only really occur if consumers are willing and able to pay for price increases across goods. And that’s what really got the Fed’s attention late last year is that it was going on across a broad swath of goods across the index. And what we’re seeing now is consumers are less able. There is a lot of kind of aggregate savings in the economy, but when we look at the median household, they’ve pretty much drawn down a lot of the pandemic era savings and people are being a lot more choosy.
And what that says to me is, yes, we’ve got a problem that’s emanating from the war in Ukraine. You’ve got higher energy prices. You’ve got food prices and those are absolutely worth talking about. But the real difference here is as those take up more and more of a consumer’s ability to spend, they take away from the ability to purchase other goods and that’s going to pull down on the prices of those other goods, and we’re already starting to see that.
And then I’ll also add on, just as we sit here today, we’re watching oil prices come down quite a bit. We’ve pulled gasoline prices down over the past couple of weeks and that could contribute to lower inflation numbers as well.
TONY ROTH: One of the great things about inflation is that to the extent that inflation is demand driven, which is, you know, pretty much all the kinds of inflation that we’ve seen since the energy crisis back in the ‘70s 50 years ago, then inflation becomes a self-correcting phenomenon because you have demand disruption as a result of inflation and that takes off the pressure on the demand side and then prices come down. So, that all makes sense and that’s in line with what you’ve just articulated. But, again, I keep coming back to this headline inflation where the problem with the inflation is not so much demand but the supply problems that we’re seeing for energy and for food. And, yes, I know that the oil and gas prices have come down of very recent and I think that has a lot to do with sort of the growth scare that people see as a result of the Fed hiking rates. But it feels like when you look at inflation globally it’s still very much a supply side driven phenomenon where the components of headline, those incremental components of headline inflation seem to be still sort of out of control.
So, do you think that you can sort of say with any confidence that the headline inflation part of it is in fact coming down with some persistence and we’ve actually achieved peak headline inflation? Or are you not? And if you do think so, why do you think that? Like where do you see that in the data like?
LUKE TILLEY: Yeah, sure. And I think it’s worth pointing out here that there are two measures of inflation, CPI and PCE, and this really gets into the weeds. I think there’s a lot more focus on CPI. That’s what spooked the Fed a couple of weeks ago and definitely got attention from markets. But last week, when the PCE was released, it did show that we’ve already passed the peak in inflation and core is moving down much faster. So, there’s differences between the two. And CPI surprised to the upside, as we were saying before, and surprised me and a lot of people in the industry. And on a one-month basis there was just a, an enormous increase that was a surprise in a couple of small items like airfares, used cars and trucks which surprised to the upside again even though we know that that’s been an issue. And those couple of things are the major differences between two indices and I don’t think that they are going to keep up.
So, there’s sort of a methodological, there’s sort of a which index are you looking at. But then also, when you look at the differences between those two things, the two major indices, the things that really surprised us in the CPI in the May data, you know, that we received in June I think are going to end up moving down.
So, where do we see it in the data? It’s in those couple of things that seem to have spiked on a one-month basis. We already know that a lot of the consumer goods that I mentioned before that are at retailers are moving down, actually moving down in price. And we’ve seen some encouraging slowdowns in some other items like healthcare in the PCE, like recreational services, those things that received such a boost.
There is a major risk and that’s coming from housing and the housing component, because it is a large part of the index. It surprised to the upside in the most recent inflation report. On a monthly basis it had on the owner-occupied side the biggest monthly jump since 1990. And we also know that that housing is both important to people. It’s a large share of their income and it also tends to be very persistent.
So, even as I say I think that we’ve hit the peak in the inflation numbers and as we look through all of the things that are starting to decelerate, we do have housing as a major issue here because it proves to be persistent usually. So, that’s a major risk as we go forward this year.
TONY ROTH: I’ve focused a lot in this conversation on the headline inflation. But to the extent that the core inflation has been more persistent than we thought it would be and that’s not the fully story, right? Because as you’ve said we think that the core currently has peaked and is now coming down because when you look at things like goods, healthcare, and other really big components of core, they’re coming down.
But the one area that hasn’t is the housing and that’s somewhat surprising to me, because when you look at mortgage rates as high as they are now and you think about the ability of renters to pay these sky-high rents and are willing to pay those rents. But consumer sentiment is as low as it’s been in decades. You think that they wouldn’t be willing to lock themselves in to longer term leases. What are the factors that’s driving the cost of housing to continue to rise so quickly and how do you think those will potentially level off and eventually come down?
LUKE TILLEY: It’s such an important part of the inflation story and by extension what sets us up for what the Fed’s going to do, what markets are going to do. And we do expect it to slow down. But there’s going to be some delays.
So, what has been driving it? There’s been a fundamental increase in demand for housing. There was a lot of movement out of cities and rental and towards living in the suburbs or buying your own home or wanting a little bit more elbow room. So, there’s a, like a fundamental shift in demand. And then, we also know that interest rates were very accommodative for quite some time, low mortgage rates, and that is going to encourage demand and that has pushed prices up. And late last year and even into this year, it started to feel a little bit like the housing boom from 15 years ago with stories of, you know, queues of people waiting to see or offers coming in sight unseen and waiving inspections. And that is just a sign that demand is so strong, and you expect the prices to move up.
Since the Fed has gotten hawkish about six months ago, a little bit more than six months ago, we’ve had the largest level increase in mortgage rates, almost a doubling of the national average of the 30-year mortgage, and that’s the largest increase that we’ve seen since 1981. And we have seen that play through now to housing activity, the National Association of Home Builders, their foot traffic index, their sentiment.
TONY ROTH: But not prices.
LUKE TILLEY: Not yet. Pending sales, mortgage applications, all of those things have come through. We haven’t seen it come through in the prices yet because there is a delay.
TONY ROTH: So that’s normal. In other words, housing prices tend to be very sticky because once buyers see the market attain a certain level they don’t want to miss out. They – it’s sort of a FOMO factor and so they’re going to be very, very insistent on waiting to get that price until they just can’t hold on anymore and then they’re going to start dropping.
LUKE TILLEY: I know what my neighbor got, so I want to get that too.
TONY ROTH: Right. So, I guess the housing market really is sort of a lagging indicator on the economy, not really a leading indicator.
LUKE TILLEY: Yeah. And there’s actually, there’s going to be two lags here. One are all the things that you’re describing, which is the behavioral thing. Two is just even if home prices just flatten or don’t really move anywhere from here, it takes, you know, a month, two months for a contract and the price and then the execution. So, it takes a little while for it to show up in the home price data.
And then, there’s this wonky methodological thing in the way that it’s going to play through to the inflation indices just in the way that they collect the data, and they sort of go around and check in on houses every six months or so. Because of that, when we look over the historical data, if you go back to the housing boom and sort of the bottoming out, it’s actually about 14 months that it takes for the year-over-year change in house prices to play through to the CPI.
And that sounds kind of, you know, wonky but it’s also really important, because we’re sitting here looking at the inflation numbers that the Fed is going to be looking at, how is that going to affect, you know, their hikes and whatnot? And even though we can explain some of those things away, the fact of the matter is historically it takes a long time for a peak in housing prices to show up in the inflation numbers. So that’s another way that it’s sticky. There’s a real delay, as you discussed, in people’s behavior and then there’s this methodological delay. And both of those things combine for maybe, you know, some challenging persistent numbers for core inflation as we go through the second half of this year.
TONY ROTH: What proportion of that core inflation number is housing?
LUKE TILLEY: Housing is about one-third of the overall index. So, it’s already a massive part of the overall index. And so, it’s an even larger part of the core.
TONY ROTH: Okay. So then, coming back to the overall second half of the year, you’re suggesting that the economy will, on a real basis, do maybe 4% for the second half of the year or maybe even better than that, because we were down 1.6 in the first quarter. So how does that play out? Does it just jump right back up in the second quarter or does it gradually accelerate as you get into the, towards the end of the year?
LUKE TILLEY: We don’t actually have the second quarter numbers yet. You know, there’s the Atlanta Fed Tracking, which is tracking at actually a negative right now, which would get you to the second negative quarter, as you said. But we, it remains to be seen if it’s going to be as deep as that. Their inventory number is pretty deep.
But we do expect to have growth for the year, and it would be a recovery in the second quarter probably from the inventory side and then some acceleration of consumer spending and also of capex in the second half of the year, because the economy has certainly slowed relative to what it was last year. But last year we were bouncing out of a very deep hole. And as I said, consumers and capex are – were still pretty strong in this first quarter, even though they were thrown off by inventory. So, we’re still looking at a pretty solid consumer and solid capex and that’s going to continue through this year we think.
TONY ROTH: So, to date, we’ve had about 150 basis points of rate hikes this year. Do I have that right? We’ve had a 25, a 50, and a 75.
LUKE TILLEY: Yeah.
TONY ROTH: So, the Fed funds rate is sitting around 1.75 or so.
LUKE TILLEY: Yes.
TONY ROTH: And we think the neutral rate is probably between 2 and 3% someplace?
LUKE TILLEY: Two to 2.5.
TONY ROTH: Okay. And so, by the neutral rate I mean the rate at which monetary policy is broadly neither stimulative nor contractionary in its impact on the economy. So, the Fed is still sort of behind the curve. Their policy is still pushing the economy forward and they want to slow the economy down a little bit to help break this inflation.
So, in July and in just another week or so, they’re going to be probably moving another 75 basis points the market believes. That’s the consensus.
LUKE TILLEY: Today, the market is probably seeing closer to 75 than 50, yeah.
TONY ROTH: So, that would bring the actual policy rate higher than the neutral rate, somewhere in the vicinity but maybe a little bit higher than the neutral rate.
LUKE TILLEY: Yeah.
TONY ROTH: So, once we get to that point, what do you expect for the rest of the year from a Fed monetary standpoint, a Fed policy standpoint? How many more 25 basis point hikes would you see going forward in the rest of the year? After the next 75 if that’s what we get, that would be 250 for the year. So that would’ve been 10 quarter basis point hikes this year. So, how many more do you see after that?
LUKE TILLEY: I think that when we get to the second half of this year that a lot of the things that we’ve talked about with goods and services and we’re going to see some slower inflation numbers. And what that’s going to translate to is the Fed being able to slow down their rate hike path, especially relative to, you know, these big hikes that they’ve done, the one from just a few weeks ago. And we’re expecting them to come in under their projections.
So, they’re talking about ending the year and their projections have them at 350. I think it’s going to be lower than that to about 3%. But clearly, this hinges very significantly on the inflation numbers, which have been challenging to predict. That the trajectory right now, and I think this is really important, especially as you’re asking about, you know, is the Fed funds rate restrictive or not. By the measures that we’re talking about with 175 today, you know, and a couple of weeks from now it will be restrictive by that measure because you’ve gone above 2 or you’re between 2 and 2.5.
However, I don’t think that tells the entire story. And just like to get to the punch line, are mortgage rates restrictive right now even though the Fed is still below their neutral rate? Absolutely mortgage rates are restrictive. They’ve pulled back on the housing market in a significant way.
So, that’s just another way of saying that the way that the Fed has communicated and pushed a lot of their future rate hikes into current market pricing, treasury yields, and those mortgage rates, that they’ve already applied the brake a little bit and that that’s going to have that impact and act to slow inflation as we go forward. And I think that we’ll end up getting less rate hikes than they think.
TONY ROTH: So, if we do get 75 in July, we could get as few as two more quarter point hikes the rest of the year.
LUKE TILLEY: At the 75, yes. And it’s also possible that they go with the 50 basis points when it comes in July. Then there would be, you know, three more after that that would get you to the 3%. You know, at the broadest level I just, I think we’re set up for that inflation slowdown, which would be welcome after all of the rapid increases that we’ve seen.
TONY ROTH: So, before we end the conversation, it is – it behooves us to talk about some areas outside the US because, you know, more than many other cycles that I can remember this really feels like a fairly synchronized global situation as it relates to inflation. We are seeing this inflation that started here in the US but now it’s manifesting itself very acutely everywhere, Germany, the UK clearly. We can’t talk about everywhere, so let’s just talk about Europe.
And, Luke, I think that it feels like Europe is further behind the curve because they haven’t raised at all, of course, where we’ve already raised, what did we say, I think essentially seven times this year, seven quarter point raises already this year, which could go to ten by July. And the ECB is not expected to raise in July. So, they, or they’re way behind the curve from an inflation standpoint. And then, at the same time their economies seem to be weaker
So, are you as optimistic about their ability to avoid a meaningful recession or you think that they potentially have more trouble ahead than we even do?
LUKE TILLEY: Yeah. It’s a good point and an important one, because it is synchronized, global inflation, a lot of it coming from the supply chain issues. Basically, most economies are seeing a multi-decades high in inflation and Europe is no different, even before the war, with Russia’s war on Ukraine. But what we’ve seen since then is even higher inflation there driven by energy prices. They do have a similar inflation dynamic to us, but so much more of it is concentrated in energy and natural gas and so those specific items, which is challenging their growth outlook.
I do think that Europe is in a more precarious position in terms of their recession versus growth scare position, a lot of it coming from the war there. So, we’ve seen their manufacturing slow down similar to the US but even more so because of supply chain issues. We’ve seen their services sector just recently take another leg down in a slowdown. So, they are closer to weakness and closer to a recession than the US is. And as you said, the central banking is a little bit behind in terms of months they – stopping their purchases now, have yet to hike, but because of those inflation problems that they have they’re sort of in line to and to try and bring inflation under control.
So, on a relative basis the European economy is much weaker than the US is and closer to that recession call. And if their inflation persists, then that’s going to have their central bank still sort of tightening the screws to try and get the inflation problem under control. But it’s clearly a little bit different with the energy dynamic there coming from the war.
TONY ROTH: Yeah. As much as we’ve been affected from a headline inflation standpoint by the supply/demand balance of gas, as well as natural gas, the Europeans are far more directly exposed to the consequences of the war with 40% of their natural gas coming from Russia.
So, from an investing standpoint, it’s something that we keep a very close eye on. And we are, indeed, very much focused on not the overall risk portfolio, but the regional distribution. So, right now we’re very neutral across the portfolio because we feel there’s so much uncertainty.
But as we go through the year from here, what we’re going to be focused on is confirming what Luke has described that we have in fact peaked from not only a core inflation standpoint but maybe even a headline inflation standpoint. Or maybe the peak is forming now on headline inflation. And then we’ll have to measure and calibrate how fast inflation starts to come down. And it’s conceivable by the end of the summer or maybe even a little later in the year that the markets regain some significant strength here in the US if in fact Luke’s forecast is correct.
And so, what we’re going to be looking for in terms of reinvesting in markets, in equity markets in a more robust way are a couple key things. One is to confirm that that inflation head, if you will, has formed itself and here in the US, and then that inflation is starting to come down. The other thing will be the market level. So, there are various drivers of markets in addition to what we’re talking about directly related to inflation, the earnings levels, earnings estimates, whether earnings estimates are coming down faster or not, perceived geopolitical risks. There’s an election coming up at the end of this year and even apart from the outcome of the election there’s a lot of stress around the system here in the US, the political system, how that plays out.
So, there’s a lot of opportunity consistent with our forecast to see the market come down another 10% over the next few months. And if that were to happen and our inflation forecast starts to bear itself out, that would really give us the greenlight I think to start to move and reinvest more aggressively in equities.
So, Luke, I’ll give you the final word here. Any final pieces of advice for folks to watch, to keep an eye on specifically
LUKE TILLEY: Yeah. I think I could talk about inflation and all the components for an hour and dig into each little bit of it. But if it was to be short, I’d say just watch energy, because energy prices flow through to so many different parts of the economy and to inflation. We can talk about core as excluding food and energy, but you never really exclude energy. So, if I only had one thing that I was going to watch, that would be it because it’s a good indicator and that’s going to be a big determinant of it, Tony.
TONY ROTH: All right. Well, we’re glad to see that oil is down. You know, gas is coming down as you mentioned. So, hopefully that’s going to be a trend.
So, thank you so much, Luke. Great conversation halfway through the year and we’re all hoping that you’re correct.
LUKE TILLEY: Me too.
TONY ROTH: So, thanks again for listening, everybody, today. Don’t forget to go to wilmingtontrust.com for a full roundup of all of our thought leadership in both the investment and the planning and tax planning areas. Thanks again for listening today.
This podcast is for information purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or recommendation or determination that any investment strategy is suitable for a specific investor.
Investors should seek financial advice regarding the suitability of any investment strategy based on the investor’s objectives, financial situation, and particular needs. The information on Wilmington Trust’s Capital Considerations with Tony Roth has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust as of the date of this podcast and are subject to change without notice.
Wilmington Trust is not authorized to and does not provide legal or tax advice. Our advice and recommendations provided to you is illustrative only and subject to the opinions and advice of your own attorney, tax advisor, or other professional advisor.
Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will be successful. Past performance cannot guarantee future results. Investing involves a risk and you may incur a profit or a loss.
Any reference to company names mentioned in the podcast should not be constructed as investment advice or investment recommendations of those companies.
Facts and views presented in this report have not been reviewed by and may not reflect information known to professionals in other business areas of Wilmington Trust or M&T Bank and may provide or seek to provide financial services to entities referred to in this report.
M&T Bank and Wilmington Trust have established information barriers between their various business groups. As a result, M&T Bank and Wilmington Trust do not disclose certain client relationships or compensation received from such entities in their reports. Investment products are not insured by the FDIC or any other governmental agency, are not deposits of or other obligations of or guaranteed by Wilmington Trust, M&T Bank, or any other bank or entity, and are subject to risks including a possible loss of the principal amount invested.
Private market investments are only available to investors that meet the U.S. Securities and Exchange Commission’s definition of qualified purchaser and accredited investor.