Macroscope | Inflation will drag down growth, but US should avoid recession this year

Persistent inflation, widespread uncertainty and an increasingly hawkish Fed have spurred concerns that the US economy could slip into recession

While the risks of a severe downturn have risen, strong corporate and household balance sheets should provide a buffer against tighter financial conditions

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Shoppers check out the products at a Safeway grocery store in Annapolis, Maryland. US inflation continues to rise despite the Federal Reserve’s best efforts. Photo: AFP

Published: 1:30am, 4 Jun 2022Updated: 2:27am, 4 Jun 2022

The relationship between inflation, growth and monetary policy has been a key driver of equity market performance recently. As the US Federal Reserve continues to raise interest rates in an effort to steer inflation towards its 2 per cent target, investors have started to worry about the negative impact on US growth, which has led to sharp corrections in US equities since April.

The seven-week losing streak on the S&P 500 index, the longest run of weekly losses since 2001, ended last week. Investors have dialled back their expectations of aggressive monetary tightening by the Fed amid weaker economic data and signs that US inflation might have peaked.

The US inflation picture has changed significantly in recent months. The rapid rise since mid-2021 has been driven mainly by higher goods prices caused by a sudden surge in consumer demand for physical products when factory output was constrained. One prominent example is used car prices, which surged in the past year because of tight supply.

In the past few months, US inflation has been showing signs of a widespread economic overheating, particularly with the rise of prices in services. Prices of core components hit above a 5 per cent annualised rate in April. Rising wages in a tight labour market have put further pressure on services inflation.

At the same time, economic reopening unleashed pent-up demand in services consumption such as tourism. Meanwhile, core goods prices – those that exclude food and energy – are no longer rising sharply, but they have fallen short of expectations that they would ease this year.

While the year-on-year US inflation rate has started to fall, the monthly pace continues to be above the Fed’s target. In fact, the average US core inflation rate between February and April annualised to around 6 per cent. The broad-based acceleration in services inflation, combined with strong wage gains, suggests that inflationary pressure in the US is unlikely to dissipate on its own.