Economy to Slow & Recession Fears to Return?

The Federal Reserve may be easing interest rates, but many other forces remain contractionary for future economic growth.

A Personal Note: This piece was written yesterday morning before the Fed’s press conference and interest rate decision. My thinking, however, changed little since the announcement. Second, unless something extraordinary happens, I plan on taking next week off to enjoy the holiday! I’ll be back in the New Year. Most importantly, I want to THANK each of my subscribers for signing up and reading my missives. This old investor is grateful for each one of you. Have a Wonderful and Blessed Season!

As the Federal Reserve met this week to decide whether to again cut interest rates, they were faced with considerable evidence of a healthy economy not obviously in need of assistance. Third quarter real GDP was a very healthy 2.8% and the Atlanta Fed’s GDPNow estimate for 4^th quarter growth is currently 3.14%. Weekly jobless claims as a percent of the labor force remain near post-war lows and although payroll employment growth has slowed to about 1.5% in the last year, productivity growth remains remarkably solid at 2.2% year-over-year and 2% in the most recent quarter. Finally, both U.S. corporate profits and the S&P 500 Index are within a whisper of all-time record highs. Inflation reports have also recently been a bit more concerning. The annual rate of CPI inflation has increased from 2.4% to 2.7% in the last two months, PPI inflation jumped from 2% to 3%, and annual wage inflation has accelerated from 3.6% in July to 4% last month.

Overall, many are questioning whether the Fed should pause its easing campaign. Continuing to ease significantly in an already healthy economy risks reigniting inflation fears. Indeed, some Wall Street firms are forecasting that the 10-year Treasury yield could soon reach 5% or even as high as 6%. At the same time, stock market bullishness has become more noticeable in recent weeks. Some market veterans expect the combination of solid economic conditions and Fed easing to potentially produce a melt-up in the stock market. Like most times, confusion abounds!

Follow the Fed at your own Peril

In my view, most of the current confusion comes from the same source it has since the pandemic – the Federal Reserve. The Fed continues to employ the same “backward” approach it has throughout this economic cycle. Compared to historic norms, this Fed has eased when it should have tightened and tightened when it should have eased.

When consumer price inflation first began rising in mid-2020, the Fed remained in an easing mode for almost two years until March 2022. During that time, the annual inflation rate surged from 0.1% to 8.5% before the Fed finally started raising interest rates. That is, in unique fashion, the Fed maintained an easy monetary policy throughout almost the entire post-pandemic inflationary surge. Then, when inflation did finally peak in June 2022 and started to moderate, the Fed kept raising interest rates despite inflation declining from 9.1% to 2.5%. Again, in unique inexplicable fashion, the Fed tightened policy throughout the entire post-pandemic disinflationary cycle. Finally, since September, in a rare if not unique fashion, the Fed has chosen to start easing again despite an economy which appears quite healthy, when the stock market is setting almost daily record highs, and when some inflation indicators are rising again.

Fed policy was upside down or backwards when inflation was surging, it was upside down or backwards as inflation declined, and it now again appears upside down or backwards easing into a solid economy and a frothy Bull market. Most felt the Fed was behind the curve when it kept interest rates at zero as inflation rose and feared that inflation would rise unchecked. However, inflation peaked in 2022 even though the Fed had only just started to tighten. Despite the Fed keeping the Funds rate near zero until almost mid-2022, the stock market nonetheless tumbled by 26% in 2022. Fed ease did not keep the Bear away. Most expected a recession and a bear market once the Fed kept raising interest rates after mid-2022 as inflation was moderating, but the economy actually got stronger in 2023-24 and the stock market started a new Bull run and simply kept rising.

Following the lead of the Fed on the economy or the stock market has not been a good strategy since the pandemic. So why follow the directive of the Fed now as it eases into a healthy economy and ongoing Bull market? With the Fed currently easing, many anticipate economic growth will get stronger and the Bull market could be headed for a melt-up. But based on the advice from this “backwards Fed” since the pandemic, suggests contemporary Fed easing probably implies an economic slowdown is coming and perhaps a stock market correction. I know, I know, my story sounds so “upside down and backwards”!

Inflation peaked in mid-2022 despite the Fed barely beginning to tighten because other contractionary forces had been in place – weaker money supply growth, much less fiscal stimulus, a stronger U.S. dollar, and higher bond yields. The economy did not recess after mid-2022 despite a very aggressive rate hiking cycle by the Federal Reserve because other forces turned accommodative – i.e., faster money growth, greater fiscal juice, and a lower dollar. Similarly, today, despite the Fed now easing into a healthy economy and strong stock market run, I suspect the U.S. economy is poised to slow as we enter 2025, recession fears will again likely intensify, and the stock market may finally suffer a correction. Why? Because the easing of this backwards Fed is again being offset by several other contractionary forces.

What follows is a pictorial of contractionary forces or indications suggesting upcoming economic weakness. If this proves correct, recession fears are again poised to flare, and the stock market may suffer a short-term correction. I do not expect a recession in 2025 nor a bear market. Indeed, my guess is the S&P 500 will still achieve about a 10% gain next year but perhaps only after a refreshing pullback in the first half.

Calling short-term corrections is always perilous, and I’m far from 100% confident. But considering how 2025 may turn out, currently this is my inclination. Or, perhaps, I will simply prove that I am just “upside down and backwards”?