Coming into the first quarter of 2023, we anticipated that inflation would continue to be the primary focus of the global economy, and this proved to be the case for the first sixty days of the year. Then the sudden bank failures (see John’s column above) diverted investor attention to the stability of the financial system. The subsequent reduction in credit caused by the banking crisis could help rein in spending and ultimately contribute to the reduction in inflation that the Fed has been hoping to engineer.
As of March, inflation, as measured by the Consumer Price Index (CPI), was +5.0% for the prior 12 months or 5.6%, excluding volatile categories like food and energy. This is well below the peak of 9.1% and 8.7%, respectively, which we experienced in the summer of 2022 but still far above the long-term Fed target of 2%. The Fed rate hikes have slowed inflation, and tightening credit conditions are on the horizon. We could be approaching the end of the interest rate hiking cycle, providing clarity for markets. We anticipate that the Fed may have 1-2 rate hikes left before pausing to assess the impact on inflation sometime this summer.
The fight against inflation will continue to have knock-on effects on growth and employment. The Federal Reserve is on record as suggesting that a period of slower economic growth is necessary to bring down inflation. As of the latest reading, the GDPNow estimate for Q1 2023 is +2.2% (April 10, 2023), which indicates the economy was still growing during the first quarter. However, strong Q1 growth is not anticipated to persist throughout the year even though the employment picture still looks very healthy, with the March nonfarm payroll report showing the economy added 236,000 jobs and the unemployment rate declining to 3.5%. The latest Fed projections anticipate an increase in the unemployment rate throughout 2023, with the median Federal Open Market Committee (FOMC) estimate of unemployment reaching 4.1% by year-end. Other employment and activity indicators like job openings (JOLTS) and manufacturing activity (ISM) also appear to show initial signs of slowing.
Additional economic indicators we follow also paint a positive but deteriorating picture of the economic backdrop. The Producer Price Index (PPI), which can be an early indicator of the direction of consumer prices in the future, has continued to trend downward, the most recent retail sales data (February) showed a slowdown in activity, and the National Financial Conditions Index (NFCI) has begun to show signs of tightening. We have also recently started seeing sentiment indicators like the University of Michigan Consumer Sentiment Survey show that consumers may be getting concerned about the economy.
We will continue to monitor economic data for additional signs of a slowdown. While evidence of economic headwinds continues to mount, we still believe there is enough resilience in consumer finances to limit the depth of any downturn later this year. We also anticipate the robust consumers, who account for two-thirds of economic growth in the U.S., will keep corporate profits from declining too severely.