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More Rate Hikes + Soft Landing: Incompatible

Having eased financial conditions through much of January and early February, the financial markets now believe that taming inflation might not be the slam dunk that Q3 and Q4 data had suggested. In addition to the over-the-top Seasonally Adjusted Payroll and Retail Sales reports earlier this month, the latest three inflation gauges (Consumer Prices (CPI), Producer Prices (PPI), and Personal Consumption Expenditures (PCE)) all came in hotter than expected. (Note: We believe that one month’s inflation data is not a trend, especially given the rapid downtrend in inflation over the past six.)

Nevertheless, as discussed in our last blog, the fixed-income markets threw in the towel last week (February 17), conceding that the Fed was on a mission to raise rates and keep them higher for longer.

This week (February 24), the equity markets began to fold. The table shows that the major equity indexes marched higher in January. Given the Payroll and Retail Sales reports, except for a slight hesitancy from the Dow Jones, continued higher through the week of February 17. Then, like its fixed-income brother, the equity markets appear to be having second thoughts about near- and medium-term economic conditions. Note that while all the indexes except the Dow are still positive for the year (second last column in the table), they all shed about -3% of their value last week (previous table column).

Interestingly, on Friday morning (February 24), at a monetary policy forum sponsored by the University of Chicago’s School of Business, a paper authored by several noted economists, including former Fed Governor Frederic Mishkin, said:

  • There is no post-1950 precedent for a sizeable… disinflation that does not entail substantial economic sacrifice or recession.
  • We find no instance where a central-[bank] induced disinflation occurred without a recession.
  • …our analysis casts doubt on the ability of the Fed to engineer a soft landing in which inflation returns to the 2 percent target…without a mild recession.

It’s not like there isn’t tons of evidence strongly correlated with the Recession (like the Conference Board’s Leading Economic Indicators, the inverted yield curve, or the business surveys). We’ve been wondering why it has taken so long for the financial markets, especially the equity side, to see the oncoming Recession. Yes, the Payroll and Retail Sales numbers appear strong, but in both cases, the raw, underlying data (i.e., Not Seasonally Adjusted) were eye-popping (-2.5 million jobs; -$100 billion Retail Sales). The seasonal factors change very slowly and don’t account for the recent behavior changes caused by the pandemic. In the Household Survey, we find that no full-time jobs have been created since last May. And after poor holiday sales, more unwanted inventory went on sale than was the case in previous years. Because the seasonal factors can’t deal with such matters, the Seasonally Adjusted data aren’t reliable indicators of the underlying trends.

The chart above shows what the annualized changes in Retail Sales look like after adjusting for inflation (red box on the right-hand side). Clearly, the free money stimulus is in the rearview mirror.


Housing has always been a reliable indicator of the health of the economy. The chart above shows the steep fall in existing home sales, now below the lows of the pandemic economic shutdown in 2020 and approaching the lows of the financial crisis 15 years ago. And, of course, as demand fades away, prices follow. The chart below shows the annual percentage changes in the median home price. It fell from +25% (June 2021) to now just barely positive from year-earlier levels. No doubt this will turn negative in the near future.


Delinquencies are rising in both credit card and auto loans. The chart below shows subprime auto debt delinquencies. Note how similar the current “up” pattern looks to what occurred during the Great Recession.  This is a reliable indicator of the health of the working middle class.

Now, look at bank credit. The left-hand side of the chart below shows that demand for auto loans and mortgages has tanked since the Fed began raising interest rates in Q2 2022. The demand for credit cards and commercial loans stayed buoyant for a while but has now also succumbed.

Mortgage applications fell at double-digit rates the week of February 17 (-13.3% from the prior week) as mortgage rates did an abrupt about-face when the fixed income markets reversed course and tightened financial conditions. As noted in past blogs, banks are now rapidly tightening credit standards (right-hand side of the chart). These are not good signs for an economy dependent on credit.

Commercial Real Estate

In Tuesday’s edition of the Wall Street Journal (February 21), a headline read: Office Landlord Defaults Are Escalating as Lenders Brace for More Distress. The article cited recent office building defaults, one in L.A. and the other in NYC. According to Owen Thomas, the CEO of Boston Properties, “Commercial real estate markets are currently in a recession.” The growing number of distressed office buildings reflects a recognition on the part of both owners and lenders that the robust return to the office isn’t likely ever to materialize. Office vacancy rates are now 12.3%. Pre-pandemic, they were 9.2%. In addition, sublease offers are the highest ever recorded. (see https://www.wsj.com/articles/office-landlord-defaults-are-escalating-as-lenders-brace -for-more-distress-894938c0 ).

Final Thoughts

GDP grew at +2.9% in Q4. Like the jobs and Retail Sales data, the headline is misleading. The two sources of supposed strength were falling imports (less money spent on another country’s output) and rising inventories. Falling imports are a sign of consumer stress, and rising inventories are only a sign of strength if intended. In this case, rising inventories were unwanted. Business surveys show lower production schedules, and shipping rates are below pre-pandemic levels. Housing is cratering, and banks are shying away from new lending.

Both industrial output and capacity utilization fell in Q4. In the jobs market, average hourly earnings fell -0.2% in January and are down -1.8% from a year earlier, much of which appears to have been caused by U.S. employers’ move toward part-time jobs. The yield curve is inverted, and the Leading Economic Indicators have been negative ten months in a row and in 11 of the last 12. All of these have a 100% track record in forecasting the Recession.

In this scenario, the Fed continues to raise interest rates! As we have noted in these blogs, the Fed boxed itself into a corner with its move toward “transparency.” Telling the market its rate intentions aided the Fed’s initial tightening phase, as markets moved rates rapidly to where the Fed said it was headed. But, as the economy slowed and the Fed “stepped down” its rate hikes (from 50 basis points to 25), markets anticipated an end to hikes and possible rate cuts. As noted above, markets were easing financial conditions in January, much to the Fed’s dismay.

Lucky for the Fed, the January Payroll, Retail Sales, and Inflation Numbers were hotter than markets anticipated. That, and continued jawboning by Fed governors, convinced the bond vigilantes that interest rates would be higher for longer. Market interest rates have risen, and equity pries appear to be on shaky ground.

Despite recent studies by noted economists that the current path of monetary policy has resulted in the Recession 100% of the time, this Fed continues to pursue ever tighter policy, not only via rising interest rates but by contracting the monetary aggregates. History shows that a contracting money supply is another surefire indicator of the Recession (and disinflation). 

Robert Barone, Ph.D.

(Joshua Barone contributed to this blog)


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