June 17, 2022 | 13:13
Re-rating Recession Risks
Re-rating Recession Risks
“The probability of a recession within the next year is not particularly elevated.” — Fed Chair Jerome Powell, March 16, 2022, after the FOMC’s first 25 bp rate hike.
“Fluctuations in commodity prices could take the possibility of a softish landing out of our hands.” — Powell, June 15, 2022, after this week’s 75 bp hike.
The relentless strength of inflation, and the policy response needed to address it, is ramping up the risks of a hard landing for the North American economy. This week’s aggressive 75 bp Fed rate hike marks a new and more aggressive phase of the global tightening cycle, reinforcing those rising risks (Chart 1). Central banks have little choice but to push rates rapidly higher to slow demand and meaningfully dampen inflation pressures. The other option is to be more tolerant of inflation, but then run the risk that inflation expectations become unhinged, while putting a bit less pressure on the economy by not pushing rates as high, as fast. There are no good options. On balance, the combination of persistently hot energy prices spilling into strong inflation and increasingly aggressive central bank rhetoric and action points to a markedly softer outlook for the U.S. and Canadian economies.
Given that challenging backdrop, we cut our GDP growth forecasts this week for the U.S. and Canada. For the U.S., 2022 GDP growth was trimmed a tenth to 2.3%, and 2023 by a much more meaningful half a point to 1%, the latter of which is both well below consensus and potential. (Table 1 compares our call with the FOMC’s latest view: note the GDP growth rates are Q4/Q4.) We continue to expect Canadian GDP growth to clock in at 3.5% this year, thanks to a strong start, but 2023 was slashed 0.8 ppts to 1.5%. With events unfolding at an unprecedentedly rapid pace in the current cycle, we’re anticipating the economy will react faster than usual to rising rates. Accordingly, we see GDP growth slowing markedly later this year and into early 2023, barely staying above zero in both countries. We would characterize our forecast, replete with a moderate rise in unemployment rates in the year ahead, as a growth recession—or a hard-ish landing. It’s not quite outright recession terrain, but it won’t take much to push the economy there, as the risks around the outlook have risen significantly.
All About Inflation
Clearly, what will make or break the economic outlook is whether inflation cracks before even more severe monetary tightening is required. Current economic conditions have left policymakers in a serious bind. Waiting too long to tighten policy has allowed inflation to take root, and has brought the credibility of inflation targets into question after decades of building. As a result, central banks will have to tighten through economic and financial-market disruption in order to preserve that credibility. That leaves us with a potentially binary outcome over the next 18 months or so: Either inflation backs off partly on its own and central banks don’t have to tighten as much as is priced into the market; or they do have to tighten to break inflation, destroying some demand in the process. From our vantage point, the inflation process looks very sticky and too deeply rooted for a perfectly clean outcome.
When looking at monthly inflation prints, it’s important to consider the short-term momentum, rather than year-over-year changes. While the latter might lead a ‘peak inflation’ narrative, it will prove false because of base effects (i.e., even bigger gains a year ago). The real clue will be decelerating shorter-term momentum in core inflation prints. At this point, unfortunately, U.S. core inflation shows no sign of slowing, with 1-, 3- and 6-month annualized changes still running in the 6%-to-7% range (Chart 2). Here’s a look at the various drivers of inflation, and the prospect of relief in the near term:
Goods prices: There is early evidence that inflation in consumer goods prices is levelling off. While used car prices are still swinging, U.S. core goods prices rose at a modest 1.8% a.r. in the three months through May. Given the shift in spending back toward services, and anecdotes of building retail inventories, we could see more relief on this front in the months ahead. Relief? Likely.
Supply-chain snarls: We’ve long argued that supply chain issues have been more a symptom (of excess demand), rather than a cause of inflation. To that extent, we should see some easing as goods demand cools, but acute issues remain in China with rolling COVID restrictions. The Federal Reserve’s supply-chain pressure index has encouragingly backed off recent highs, but still has a long way to go to find normal. Relief? Possibly.
Services prices: The flip side is that as spending shifts back to restaurants, events and travel, prices in those areas are getting pressured higher (Chart 3), especially considering there probably wasn’t any new capacity added during the pandemic (quite the opposite in some sectors). Hotel rates and airfares are ballooning into the summer season. Many of these services are also labour-intensive, where shortages are further limiting capacity. Relief? No.
Asset prices: Stocks, crypto and houses are pulling back after being inflated by historically-low real interest rates, but weakness in these areas won’t be sufficient to stop central banks from tightening. In the U.S., home prices filter into the CPI, but only with a considerable lag. So, even if prices are pulling back today, it will realistically be around mid-2023 before the lagged impact of higher rates starts to weigh on owners’ equivalent rent in the CPI (and that carries a hefty 24% weight). Relief? Not soon enough.
Resource prices: Retail gas prices have more than doubled over the past year and crude remains strong. At the same time, food prices are still running at a double-digit annualized clip in recent months, and tough growing conditions persist across parts of North America. While some other commodities, such as lumber, have backed off with cooling demand, food and energy will need something more significant to break—think a turn in the war in Ukraine to start. Relief? We can’t count on it.
Wages: A labour market at full employment and record job vacancies have left significant leverage in the hands of workers. Faced with escalating living costs, those workers are having success at the bargaining table, with U.S. wage growth, based on the Atlanta Fed’s measure, accelerating to above 6% y/y, or the highest since at least the mid-1980s. Wages are rigid to the downside, and a key part of inflation reinforcing itself. That said, our softer outlook could act as a headwind, but not until after more significant tightening. Relief? Not without a slowdown.
Psychology: Everyone is talking about it, and expectations of higher prices pull demand forward, which leads to… higher prices. According to the University of Michigan survey, inflation over the next year is expected at 5.4%, the highest since 1981, while 3.3% for the next five years is a notable departure from recent decades in the 2%-to-3% range (Chart 4). This clearly caught the Fed’s attention, tipping the scales to the 75 bp rate hike. Relief? No—this is what policymakers need to break.
All told, there’s not enough relief in sight for inflation to come back down on its own. And, policymakers know that the longer current price trends fester in wages and consumer psychology, the tougher it will be to crack—hence the aggressive near-term tightening of policy and risk to the real economy.
Key Takeaway: The further inflation goes and the longer it remains high, the greater the risk to the economy. While we still believe that with some luck—on oil prices, for instance—a full-blown downturn can be avoided, the economy will struggle heavily late this year and into early 2023 to grow at all.