U.S. Recession Prediction: What the Fed’s War on Inflation Means for the Economy

• We forecast that inflation will recede to normal levels in 2023 and even undershoot the Fed’s 2% inflation target by 2024.
• Down markets are opportunities to support clients by finding undervalued stocks or hedges against inflation.
• At year-end, advisors need to take the lead on conversations about the economy to show how they monitor portfolios through the downturn.

It’s a scary time for investors. Prices are going up at the grocery store and the gas pump, as inflation rose 7.7% in 2022 through October. Nest eggs have taken a beating in volatile markets. Major tech layoffs have dominated the news.

Will a recession happen in the next 12–14 months? According to Preston Caldwell, Morningstar’s head of U.S. economic research, it’s a virtual coin toss. But our analysis shows signs of relief.

During times of economic uncertainty, it pays to take the lead on conversations about the market (instead of waiting for angry phone calls). With strong underlying data, advisors can soothe anxious investors with opportunities and a plan.

In 2022, Americans endured price spikes caused by high demand and disrupted supply chains. Inflation is set to peak this year at its highest level in four decades. To curb the rise in inflation, the Federal Reserve raised interest rates by 0.75% for four meetings in a row.

In the long term, our outlook on inflation looks promising. Here’s why.

Today’s inflation is tied to specific categories instead of spread out across the economy. More than half of “excess” inflation, above pre-pandemic predictions, has been driven by the auto industry, rising energy prices from the war in Ukraine, and other core goods affected by the supply chain.

Resolving supply chain issues have begun to lower the price of goods and should continue to tamp down inflation. Caldwell forecasts that inflation will recede to normal levels in 2023 and even undershoot the Fed’s 2% inflation target by 2024.

How do GDP and inflation relate?

Real gross domestic product, or GDP, broadly measures the value of all the goods and services produced in a country, adjusted for inflation. While nominal GDP eked out gains in the first half of 2022, real GDP dipped.

But other indicators showed the health of the economy. Strong trends in unemployment rates and consumer spending indicate that the U.S. didn’t enter a recession in the first half of the year.

It might not feel like it to clients, who feel crunched by interest rates and inflation, but asking if there will be a recession misses the point. "Either way, we expect growth to accelerate again in 2024 as the Fed lifts off the brakes and pivots to monetary easing," Caldwell said.

Concrete data can dispel some of the worry and anxiety about recessions. Morningstar’s solutions curate economic outlooks in one place, making it easy to share key insights with clients. Quarterly reports can also give investors data to understand what’s happening without overwhelming them with information.

Why is core inflation a better predictor of inflationary pressure?

Core inflation removes food and energy from the Consumer Price Index. Food and energy prices tend to swing more dramatically and more often than other consumer goods, so omitting those two categories can help reveal underlying investment trends.

Inflation increased 0.4% in October per the Consumer Price Index, on pace with September and below expectations. Core inflation fared even better with a 0.3% rise, down from 0.6% in September.

“We should be wary of overreacting to just one month’s worth of data,” Caldwell said. “But even in terms of the three-month moving average, we detect a slight downtrend in core inflation.”

Most investors saw their portfolios slump from January 2021. While commodities, value stocks, and alternatives performed well, almost all fund categories saw negative returns.

The recent rise in inflation reduces the real return on investment in the short term. Tough stock markets are especially alarming for retirees who are already making withdrawals from their nest egg, as well as clients on the brink of retirement.

As the year closes, advisors need to take the lead on conversations about the economy and show how they monitor investments through the downturn. Show clients how your investment strategy fits their risk tolerance and capacity to weather volatile markets.

In down markets, advisors can support clients by finding undervalued stocks or hedges against inflation. Tools like Total Rebalance Expert can also surface tax-advantaged opportunities to rebalance portfolios.

We expect GDP growth to accelerate in 2024 as the Fed starts cutting rates to stimulate demand. Once inflation comes under control, the Fed will shift focus to shoring up economic growth.

If clients are anxious about inflation and recession, remind them not to panic. Pulling money out of the market now will lock in their losses at the low point, instead of benefiting from the eventual bounce-back.

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