Fed Is Preparing You For Recession – Are You Ready?

In this article, I will focus on what I believe is the single most important message being communicated by the Fed and that investors need to focus on. We also will discuss exceptional opportunities that are emerging from a divergence between the Fed’s stated intentions and expectations and what markets are pricing in.

The Key Message From the Fed

I believe that the most important message that the Fed is trying to transmit and that investors need to focus on is this:

In order to get inflation down to its target of 2.0%, the Fed plans to push the US economy to the brink of a recession – and potentially beyond.

The above message was clearly articulated to the public on Wednesday, Dec. 14, 2022, through the following communications channels, which I will cite from throughout this article.

1. FOMC Statement
2. Summary of Economic Projections (SEP)
3. Powell’s Press Conference Opening Statement
4. Powell’s informal remarks at the press conference

Below I will delve into detail on exactly how, and to what extent, the Fed has communicated the aforementioned message. The message is divided into two parts. A) Communication of the Fed’s overriding commitment to get inflation down to 2%. B) Communication of the Fed’s intention – pursuant to their overriding goal of getting inflation down to 2% – to push the economy to the brink of recession, and potentially beyond.

Getting Inflation Down to 2.0% is the Fed’s Overriding Goal

In the FOMC statement, Opening Statement to the Press Conference and during the Press Conference, Federal Reserve Chair Jerome Powell went to great lengths to emphasize that the Fed’s overriding goal was to get inflation down to its 2.0% target. Repeatedly and forcefully, Chair Powell emphasized that the objective of getting inflation back down to 2.0% was paramount and superseded any other consideration at the present time – including the risk that the US economy might fall into recession due to the Fed’s inflation fighting measures.

The following is a sampling of such statements by the Fed Chair:

1. “We are strongly committed to bringing inflation back down to our 2 percent goal.”

2. “We are highly attentive to the risks that high inflation poses to both sides of our mandate, and we are strongly committed to returning inflation to our 2 percent objective.”

3. “We have more work to do. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy doesn’t work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all.”

4. “Inflation remains well above our longer-run goal of 2 percent… The median projection in the SEP for total PCE inflation is 5.6 percent this year and falls to 3.1 percent next year, 2.5 percent in 2024, and 2.1 percent in 2025; participants continue to see risks to inflation as weighted to the upside.”

5. “The labor market continues to be out of balance, with demand substantially exceeding the supply of available workers.”

6. “We are taking forceful steps to moderate demand so that it comes into better alignment with supply. Our overarching focus is using our tools to bring inflation back down to our 2 percent goal and to keep longer-term inflation expectations well anchored. Reducing inflation is likely to require a sustained period of below-trend growth and some softening of labor market conditions. Restoring price stability is essential to set the stage for achieving maximum employment and stable prices over the longer run. The historical record cautions strongly against prematurely loosening policy. We will stay the course, until the job is done.”

7. In response to a question about whether the Fed might consider raising its inflation target above 2% if inflation proves stickier than expected, Chair Powell was emphatic. “Raising our inflation goal above 2% is not something that we are thinking about; it’s not something we are going to think about. We have a 2% inflation goal and we’ll use our tools to get inflation back to 2%…. The Committee is not considering that; we are not going to consider that under any circumstances. We are going to keep our inflation target at 2%, and we are going to use our tools to get inflation back to 2%.

In sum, the Fed’s overriding goal is to bring inflation down to 2%. As we shall see below, the Fed is clearly communicating to the public that in order to achieve this objective, the Fed has already taken a series of measures, and will take a series of further measures, which may push the US economy into a recession.

Intentionally Pushing the US Economy to the Brink of Recession?

From the SEP, it’s implicitly clear that in order to bring inflation down to 2.0%, the Fed is actively planning to push the US economy to the brink of recession. Indeed, if US GDP growth slows down by as much as SEP forecasts are indicating, and/or if the unemployment rate rises by as much as the SEP is forecasting, history suggests that the US economy will, more than likely, lapse into a recession.

1. Deceleration of real GDP growth to +O.5% YoY – below stall speed. SEP projections indicate that Fed officials believe that it will be necessary for US GDP growth to decelerate to a rate of 0.5% in 2023 in order for core PCE inflation to get down to their projected level of 3.5% in 2023 and 2.5% in 2024.

A decline in the US GDP growth rate to 0.5% would, in the best-case scenario, take the US economy to the brink of recession. Indeed, historically, a decline in the 12-month growth rate of GDP to 0.5% or below has always resulted in the US economy going past the brink, into recession.

According to my research, since WW2, there has never been an instance of YoY real GDP growth decelerating to +0.5% or below that was not associated with a recession. In fact, since WW2, all historical instances of deceleration of GDP YoY real GDP growth to 0.91% or below were ultimately associated with a recession.

2. Increase unemployment rate by 1.1%. The SEP indicates that Fed officials believe that it will be necessary for the unemployment rate to rise by 1.1% from the most recent cyclical low (implying a loss of well over 1 million jobs) in order for core PCE inflation to get down to their projected level of 3.5% in 2023 and 2.5% in 2024.

A rise in the unemployment rate to this level would, in the best-case scenario, take the US economy to the brink of recession. Indeed, historically, such a rise in the unemployment rate has always been associated with a recession.

According to my research, since WW2, there has never been an instance in which a rise of in the unemployment rate of 1.0% or more has not ultimately preceded a recession. Indeed, since WW2, every single time the unemployment rate in the US has increased by 0.8% or more, a recession has occurred. Since 1960, the largest increase in the unemployment rate that was not associated with a recession was 0.4%

In sum, the Fed is enacting anti-inflation policies that it knows are pushing the US economy to the brink of a recession. Furthermore, to the extent that GDP growth slows as much as the Fed expects and/or unemployment rises as much as the Fed is forecasting, history suggests that the US economy will most likely lapse into a recession.

Fed Is Preparing the Public for a Potential Recession

Powell reiterated in the Dec. 14, 2022, press conference something that he has emphasized in recent statements: Although a soft-landing scenario that avoids recession is possible, the window for such an outcome is rather narrow. When pressed on whether he thought there would be a soft landing or a recession, Powell said that he did not know and that “nobody knows”. He also said that if there was a recession “nobody knows” how severe it will be.

The clear implication in these comments is that the Fed is fully aware that there’s a very good chance that the upcoming economic slowdown (reflected in SEP forecasts) will ultimately lapse into a recession, and that this is a risk that the Fed is ready and willing to take.

Furthermore, at this press conference, Powell once again reiterated his belief that if a recession is necessary to get inflation down to the Fed’s 2.0% target, then it will be well worth it. In reference to the “pain” that the upcoming economic slowdown could cause, Powell stated:

“The largest amount of pain, the worst pain would come from a failure to raise rates high enough and far enough and allowing inflation to become entrenched in the economy, so that the ultimate cost of getting it out of the economy would be very high, in terms of very high unemployment for extended periods of time. The kind of thing that had to happen when inflation got out of control and the Fed didn’t respond aggressively enough or soon enough in a prior episode, 50 years ago. That would really be the worst pain, if we failed to act… What we are doing now is raising interest rates for people and people are paying more for mortgages and that kind of thing and there will be some softening in labor market conditions. I wish there were a completely painless way to restore price stability, but there isn’t. This is the best we can do.”

Investment Strategy Implications

The Fed is telegraphing their policies and clearly stating that these policies will bring about a substantial risk of recession.

However, this brings about a very interesting situation. if there were indeed a recession in 2023, due to the transparency in the Fed’s communications, it would probably be the most widely anticipated recession in history – at least in terms of economic forecasters. On the surface, this would suggest limited opportunities to exploit the risk of recession via top-down portfolio strategy.

But one needs to ask: What’s actually priced into financial markets? The conditions that forecasters expect and what the market is pricing in are two very different things. Numerous indicators suggest that there’s a significant divergence that has developed between what economic forecasters expect and what financial markets have priced in. Examples:

1. High-yield corporate bond spreads are at historically low levels, implying very little risk of recession is currently being priced into this segment of the US bond market.

2. On aggregate, the implied equity risk premium for US common stocks is at historically low levels, suggesting very little risk of recession is priced into US equities.

The above suggests that there is a potentially exploitable divergence that has developed between what is priced into financial markets and the expectations of economic forecasters – including the Fed’s own forecasters.

So, what should investors do?

To the extent that investors believe risk of recession is substantial – as the Fed itself appears to believe – then the divergence referenced above is presenting many strategic opportunities from a portfolio management standpoint. Not all of these opportunities are obvious. To this end, we’re busy educating our subscribers at Successful Portfolio Strategy about various strategies and instruments that they may have limited knowledge of such as various sorts of high duration Treasury securities, including zero coupon securities and TIPS (including specific closed-end funds and ETFs that specialize in such securities). We also have been very busy exploiting various opportunities that have been emerging internationally as a result of the current unique set of global financial conditions.

At Successful Portfolio Strategy, we’re positioning for very significant opportunities that we believe are emerging heading into 2023. For example, we’re currently structuring our portfolios in such a way that they should profit if the US economy manages to avoid recession. However, our base case is for a recession and our portfolios are currently unusually constructed in such a way that they will experience significant gains if a recession occurs. And we are doing all of this while assuming well-below average risk.

In sum, we believe that on Dec. 14, 2022, the markets essentially under-reacted to Powell’s message. As a result, investors are currently being presented with a very unique set of opportunities from a portfolio strategy standpoint. It’s only once in a few years that I see such asymmetric reward-to-risk set-ups emerge. 2022 has been an excellent year for Successful Portfolio Strategy, with gains of over 20% in our flagship portfolio, achieved taking relatively little risk. But given the sort of set-ups just highlighted, we expect 2023 to be an even better year.