The Recession, Inflation and the Deficit in 2023

Episode 20: In today’s episode, host Jim Ray is joined by Dr. Frank Raymond (Professor of Economics) and Mr. Carl Hafele (Investment Manager and Professor) to discuss the current state of the US economy.  Both guest have joined the podcast to discuss similar topics in Episode 3 and Episode 16.  It’s always a lively conversation.

Recession – Is It Here or Not?

Frank explains that the National Bureau of Economic Research (NBER) determines the whether an actual recession is occurring or has occurred.  While the standard definition of 2 consecutive quarters of negative GDP is the benchmark, there are other factors related to the actual determination.  He states unequivocally, that we are not currently in a recession.  The concern whether the Fed’s interest rate increases will cause the onset.  The real culprit is inflation.

Carl comments on how the market views our current recession.  The market is always ahead of the NBER.  The market exists is real-time, not an academic review of what happened in previous quarters.

Is There a Correlation between Inflation and Recession?

The Fed’s mission is to keep the inflation rate near 2%.  They have limited levers to pull to make that happen.  Unfortunately, some of those levers are sledge hammers, rather than scalpels. 

The Fed looks at the demand side of our economy.  If interest rates rise, it can have a cooling effect on demand.  However, inflation obviously causes prices to rise.  Frank explains that GDP growth and price growth normally move in the same directions.  The effect of the Fed’s move is to lower GDP growth in an attempt to stabilize upward price pressures.  Again, a cooling off effect assuming people slow purchases (especially large purchases such as housing).  As the demand softens, a natural decrease in prices should follow. 

Could an Increase in Supply Have a Similar Effect?

If prices rise because too many dollars are chasing too few goods, adding more goods should begin to stabilize and eventually reduce market prices out of an abundance of availability.  An equilibrium point will eventually be reached.

Carl describes how the Fed struggles to get the timing of its policies correct.  The may increase rates, but then have to wait to analyze how that impacted the overall market.  This is a rearward facing analysis.  The market continues to operate in a current or forward facing posture.  Carl recounts how Fed Chairman Paul Volker’s policies during the 1980s brought double digit inflation rates down to a stabilized 4% average.  It was painful, but it worked. 

In Carl’s words, unfortunately, the “Inflation Genie” has gotten back out of the bottle.”  A lot of this has been cause by the massive infusion of cash into the market, by both political sides.  It began with the great recession, then the COVID pandemic followed by massive additional spending. 

The Soft Landing vs. a Hard Landing

When the economy is struggling and inflation is adding to the complexity of the equation, the Fed is trying to make moves to ensure a soft landing.  In other words, to bring the crisis to an end without causing a fiscally catastrophic nose dive (e.g. a hard landing). 

Frank lends some perspective to the situation.  While interest rates are in the 4-5% range, historically, they remain on the low-side.  We’ve seen much worse.  People will begin to acclimate to the current levels, which actually represent true financial risk more accurately.  There’s no “free money” so people will be more careful with their decisions to make large purchases, start businesses, etc.

Frank cautions the risk the Fed is evaluating is that by raising rates too high, too quickly, the market could overreact by stalling demand of any financed purchases.  This causes a dangerous ripple effect.  The housing market is often a bell weather indicator because of the additional purchases of furniture, appliances and other related goods tied to the purchase of a new home.  Many different industries/markets are tied to the health of the housing market.

This is when negative buyer psychology kicks in.  If people delay housing purchases, because they are worried about the economy, inflation and other factors, that same mindset will negatively impact overall purchases not actually related to housing.  For the Fed, it’s a fine line.

Jobs and GDP Growth

Recently, the Fed only increased the interest rate by a ¼ point.  That’s less than previous increases, signaling a potential improvement.  However, the recent jobs report showed 500,000 new jobs.  New paychecks will logically result in demand-side increases on prices.  Will this accelerate the inflationary “too many dollars chasing too few goods”?

Frank explains over time, there’s been a gradual increase in prices.  Supply chain constrictions put price pressure on the goods.  The moves made by the Fed don’t impact the supply-side of the equation, at all.  Because we are only working one side of the equation, the demand side, will the Fed have to take more aggressive actions to achieve the balance it’s ultimately pursuing?

Carl explains that interest rates affect valuation levels all levels of asset classes.  He has a significant background in senior living projects.  Carl describes how each project has a cap rate.  At the end of 5 years they either refinance or sell it.  If interest rates increase, it changes the risk premium.  The buyer wants a higher rate of return resulting from a discount, to ensure they still hit their pro-forma cap rate.

Are We in a Sea Change?

Carl discusses economic “sea changes.”  They don’t happen often.  He notes past events, 1980-1982, the 2000 dot com bust and more recently during the great recession.  These are periods of major changes.  So, are we in a sea change, today?

Interest rates and the yield curve haven’t been like this since 2005.  Several months ago, short term bond rates were more attractive than long term rates.  This is referred to as the inverted yield curve.  During these periods, it’s better for investors to take short-term risks than to tie up money for a longer term.  Frank mentions his IU economics professor Christopher Waller, who is a member of the Board of Governors of the Federal Reserve.  He’s an inflation hawk and will work diligently to reduce inflation, as part of the Fed.  Christopher spoke a Bellarmine, in the past.

The question remains, will we enter a recession?  Frank again ties the forecast to domestic housing.  If it crashes, the ripple effect and the resulting psychological impact will be tough on the economy.  Carl notes that housing starts have already been down 12 consecutive months.

Further disruption of oil supplies could also add price pressure to the situation.  As Frank points out, we’ve been blessed with the relatively mild winter.  This eases demand for heating oil.  However, the upside is the increase in interest and investment in renewable energy initiatives.

Carl is optimistic in the long run. While the Fed got behind early, they are now focused on resolving the inflation issue.  However, the debt is another issue to watch. 

The Deficit

To boil it down, this is about our debt service payments.  Carl explains how the ever-increasing debt payments are becoming a much large share of our GDP.  This limits the funds available to address other issues in the overall US economy.  Rate increases expand this debt service cost exponentially.  The Fed can’t let this happen. 

Frank understands how extreme case can present a realistic need to take on debt to stabilize the economy.  He uses the example of the great recession and the pandemic.  However, the spending can’t continue at those level.  Taking a much more targeted approach would be much better for the economy.

Balancing the budget would go a long way towards reducing the deficit and spurring optimism, at the same time.  Frank reminds us that inflation is the friend of borrowers, because it eats away at debt. 

Carl explains that social security, Medicare and Medicaid are the major drivers because they make up such a significant portion of our economy.  Adding debt service takes away fund for parks, education and other important investments.  Over the past 50 years of studying it, Carl remains convinced it’s always a spending problem.  Again, both parties are guilty.

Government revenues have been fine for decades.  It’s the fact that we keep outspending the revenues that creates the problem and compounds it. 

Frank comments on the fact that we have much more data, compiled over our 100+ years of experience, to help us to better understand how to gauge the situation.  Unfortunately, many of the decisions made at the highest-levels involve politics.  That’s often a contributing factor to our getting it wrong at the right times.

Shocking the System to Deal with the Deficit

Carl explains that the Fed will continue rate hikes until something breaks.  What would happen if China were to stop buying our debt?  This is a serious consideration. 

Carl also suggests term limits might be a way to shock the system because the incentives to those who hold those positions would become much different than what we see today.  He wrote the book, “The Inevitable Great American Reset, Riding the Economic Rollercoaster of Capitalism.”   In 2014, he said 2022-2023 would be the time when something significantly changes.  Carl admits he got this wrong, because we’re still in the same situation.

The China Situation

Frank picks up on Carl’s comment about China.  It’s rumored China may send lethal military support to Russia to support the war with Ukraine.  We recently had the spy balloon issue.  China actually held ¼ of the entire US national debt, at one time.  US consumers buy a lot of imports.  China is an export economy.  The result is that US dollars are flowing to Chinese banks.  If the world markets decide to transition away from dollars in favor of the Chinese yuan, the yuan will appreciate against the dollar.  Chinese products will increase in price, possibly limiting or reducing the attractiveness for US and world consumers. 

So, why does the debt held by China matter?  Frank estimates they still hold about 1/5 of the US debt.  Let’s play it out. If the US were to default on the bond payments to those who hold US debt, the trust and reputation of the US would be negatively impacted.  Then, countries and banks would be less confident in buying US government bonds, which we use to finance our debt.  It could also have a ripple effect on investments in US private industry.

What Happens Now (or Down the Road)?

Frank hopes we get inflation back to the 3% or lower levels to avoid a drastic reduction in GDP.  It’s a large and complex economy.  Carl adds that the larger our government grows, the slower our GDP grows.  Government literally sucks money out of the economy that could be used by private industry to create jobs, investment opportunities and financial security.  As government grows, we compete with ourselves to fix the issues.

Carl warns of the increase in ESG.  We question whether this is the best focus for the C-suite and their obligations to their investors.  Jaime Dimon, CEO of J.P. Morgan was one of the first to reject the focus on ESG.  Determining whether to focus on the shareholder or the stakeholder is a controversial topic, for another day.  Carl notes this is a sea change.  Frank adds that the markets will eventually resolve the issue, naturally.  There is a role for both government and private investment.

Frank posits that another topic might be for us to address the issue of opportunity.  The playing field isn’t as level as it could be, so what should be government’s role in resolving this issue?  In 2015, there was a lot of discussion the 50^th anniversary of LBJ’s Great Society.  Economic history is full of examples of perverse effects.  These are the unintended consequences of policy decisions and initiatives undertaken with good intentions.  It’s a complex, but important topic to consider.

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