Hartford Business Journal Special Editions

4 HARTFORDBUSINESS.COM | ECONOMIC OUTLOOK SURVEY Inflation, rates and recession will shape economy in 2023 By Kenneth J. Entenmann L ast year was a volatile one for the economy and financial markets. The main catalyst of uncertainty has been the persistent and pervasive nature of inflation. In response, the Federal Reserve Bank has embarked on a historically aggressive monetary policy change that has quickly and significantly increased interest rates. This change in monetary policy clearly dampened economic activity in 2022. First and second quarter GDP were negative (-1.6% and -0.6%), while the third quarter GDP rebounded to 2.9%. Overall, GDP growth will be modest at best in 2022 and the economy is limping into the new year. Looking in 2023, consensus fore- cast for GDP growth reflects the sober Hartford Business Journal survey results: Growth is expected to be chal- lenged, with many forecasts calling for a recession in the first half of the year. In the post-COVID economy, it was hoped that inflation would be "transitory." Unfortunately, inflation continues to remain problematic heading into 2023. The good news is that inflation, as measured by the Producer Price Index (PPI) and Consumer Price Index (CPI), appears to have peaked. PPI peaked at 11.7% in March and was 7.4% in November. CPI posted a peak rate of 9% in June and was 7.1% in November. Both indices have declined every month since their peaks. While this trend is encouraging, inflation remains far above the Fed's 2% target. The HBJ economic outlook survey reflects this, with 46% of respon- dents citing inflation as the most impactful macroeconomic issue, and 18% recognizing inflation as the second-biggest impediment to growth — behind only taxes. Over 60% say inflation will continue to increase or peak but remain high. 'Normal' demand There continues to be three primary drivers of these pessimistic inflation expectations: supply chain disruptions, commodity prices and labor issues. While some of these factors have improved, others still are a significant concern. Supply chain disruptions have improved. At the outset of the COVID pandemic, a dramatic shift in consumer demand severely affected the supply chain. In "normal" circumstances, the U.S. economy is driven by the service sector. With the COVID lockdown, consumer demand shifted signifi- cantly to "goods." While we were in lockdown, we refurnished the house, finished the basement and replaced appliances. This dramatically increased demand for commodities and finished goods. The supply chain buckled under this change. Demand is now shifting back to "normal," meaning the consumer has returned to buying services instead of goods. Afterall, how many new refrigerators can one buy? We are back in restaurants and hotels and air traffic is at record levels. This shift in demand has allowed most commodity prices to decline. Goods inflation is diminishing rapidly, but service inflation remains elevated. Perhaps the biggest factor for infla- tion and the Connecticut economy is the labor market. It remains tight. November's unemployment rate was a historically strong 3.7%; Connecticut's unemployment rate was 4.2%. Unfortunately, this low rate is misleading and masks what is a challenged labor market. The labor participation rate (62.1%) has yet to recover to pre-COVID levels. The Job Opening and Labor Turnover report shows there are 10.3 million job openings — nearly 1.9 times the number of unemployed individuals. The National Federation of Inde- pendent Business (NFIB) Jobs Report states that 90% of small businesses report few or no qualified applicants for open positions. Of HBJ survey respondents, 54% state they cannot find qualified workers. In addition, wage growth has been growing more than 6%. These factors suggest that wage inflation will remain problematic in 2023, particularly in small business economies like Connecticut. The Fed has responded to persistent inflation by aggressively increasing the federal funds interest rate. Since March, the Fed has raised the fed funds rate from 0% to 4.75%- 5%. This is a historically fast pace for the Fed. To provide some perspec- tive, the last time the Fed embarked on a prolonged rate hike strategy, it raised rates by 3.25% over the course of three years from 2010 to 2012. The economy has reacted nega- tively to this aggressive change in monetary policy. Housing activity has been materially impacted. Mortgage rates have increased throughout the year from below 3% to over 6% and existing home sales have declined for eight consecutive months. Industrial commodity prices have declined. Manufacturing activity has slowed. M2 money supply has declined significantly, and the 2-10- year Treasury yield curve is inverted by 82 basis points, both historic indi- cators of recession. Indeed, consensus economic fore- casts suggest a 60%-plus probability of a "short and shallow" recession in the first half of 2023. Inflation a key driver The economic outlook for 2023 is challenged. This is reflected in the HBJ survey, with 32% reporting the economy will improve slightly while 32% suggest it will decline slightly. The direction of the economy will be determined by inflation. If infla- tion continues its recent trends and steadily declines toward the Fed's 2% target, it will allow the Fed to complete its interest rate hiking cycle. With the fear of further rate hikes over, the economy would be poised for renewed growth. However, the main risk for 2023 is that inflation is persistent and pervasive. Even if inflation peaks but remains stubbornly high, it will require the Fed to raise rates further and keep them "higher for longer," something the economy and markets are not anticipating. Reflecting these fears, the consensus economic forecast calls for a modest recession in the first half of 2023. Hopefully, any recessionary activity will be muted by strong corpo- rate and consumer balance sheets. The expectations are for a rough start to 2023 as the economy works through the challenge of tight labor markets and persistent inflation. It is hoped that inflation will dissipate in the first half, setting the economy and markets up for a strong second half of 2023. Kenneth J. Entenmann is chief investment officer and chief economist at NBT Wealth Management. Kenneth J. Entenmann

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