Is the Economy Out of the Woods?

Last week, there was unambiguous good news for the economy: the rate of inflation has slowed significantly. The Consumer Price Index (CPI) grew at an annual pace of 3 percent in June, the smallest increase since March 2021 and well off the peak rate of 9.1 percent seen in June 2022. The core rate, which strips out the volatile categories of food and energy, increased by 4.8 percent, the smallest annual gain since October 2021, though well-above the Fed’s 2 percent target.

A big contributor to the drop in the headline reading was energy, which has tumbled 16.7 percent since last year, when the average price for a gallon of gas was more $5, primarily due to the war in Ukraine and supply chain issues. The combination of those issues receding, and the Fed’s aggressive rate hike campaign (five full percentage points since March 2022) have made a big dent in the rate of inflation.?

Despite the improvement, I continue to hear from people who say things like, “But everything is still so expensive!” Of course, some things cost a lot more than they did prior to the pandemic, like housing prices, childcare, and car insurance. But even though we complain, surveys find that the drop in prices is making a difference in how we feel. The University of Michigan’s Consumer Sentiment Index rose in July to its “most favorable reading since September 2021. The sharp rise in sentiment was largely attributable to the continued slowdown in inflation along with stability in labor markets.”

The improvement in prices and sentiment begs the question: Is the U.S. economy out of the woods? Despite economists and analysts almost uniformly believing that the economy would fall into a recession this year, it most certainly has not done so yet. GDP expanded at an annualized pace of two percent in the first quarter of the year and estimates for the second quarter range from about 1 to 2.3 percent annualized growth. Those early recession calls presumed that the labor market would roll over, which it has not. Despite job losses in tech, banking and media, the resilient labor market has seen 30 consecutive months of job growth.

However, the Federal Reserve is concerned that further progress on inflation may not be forthcoming, as the year over year comparisons will be tougher in the second half of 2023. The Fed view does not synch up with a likely improvement in the shelter component of the CPI, which seems to lag the real-world experience of rental increases petering out, but they are the deciders, so let’s take them at their word: another rate hike is probably coming at the end of this month, which along with a general slowdown in economic data, could mean that a recession is still possible.

Analysts at Capital Economics warn: “June’s soft U.S. CPI print seems to have given investors renewed hope that inflation could fall back to normal levels without the economy slowing too much, if at all. We continue to think that the chance of a more-significant economic slowdown is underappreciated.”