Focus

December 02, 2022 | 13:29

Still Recession Bound?

Economist

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Benjamin Reitzes

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Art Woo

Senior Economist and Director
Economics

Art joined the Bank of Montreal in 2014. His primary responsibility is analyzing global economic, financial and ... (Read more)

Jennifer Lee

Senior Economist and Managing Director
Economics

(Read more)

Shelly Kaushik

Economist
Economics

Shelly joined BMO Economics in 2020 and conducts research on the Canadian and regional economies. She also provi... (Read more)

Priscilla Thiagamoorthy

Economist
Economics

Priscilla joined BMO Capital Markets in 2016 and plays a key role in analyzing Canadian household trends and the... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Benjamin Reitzes

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Art Woo

Senior Economist and Director
Economics

Art joined the Bank of Montreal in 2014. His primary responsibility is analyzing global economic, financial and ... (Read more)

Jennifer Lee

Senior Economist and Managing Director
Economics

(Read more)

Shelly Kaushik

Economist
Economics

Shelly joined BMO Economics in 2020 and conducts research on the Canadian and regional economies. She also provi... (Read more)

Priscilla Thiagamoorthy

Economist
Economics

Priscilla joined BMO Capital Markets in 2016 and plays a key role in analyzing Canadian household trends and the... (Read more)

Feature

Still Recession Bound?

Despite an onslaught of Fed tightening, the U.S. economy is holding tough. Third-quarter GDP growth was revised up to 2.9% annualized and consumer spending sped up in October. The surprising resilience puts into question calls for a mild recession starting early next year, though pulling it could prove premature.

The expansion’s durability reflects four factors. First, real rates aren’t really high. With household expectations of long-term inflation in the 3% range, the current 3.75%-4.00% fed funds target range implies a real policy rate that’s only moderately restrictive. In contrast, the real rate surpassed 2% prior to the three recessions between 1990 and 2008. Moreover, the real rate derived from core PCE inflation is still negative, and could remain so until early next year, after a further 100 bps of tightening and declines in inflation. For context, real policy rates prior to the seven recessions between 1970 and 2008 were never below 3% (Chart 1).

Second, monetary policy works with a lag, as rate hikes often take four to six quarters to fully clamp down on demand. This means the impact of the Fed’s previous and prospective moves may not fully hit home until well into 2023 or even 2024.

The third source of economic support is the thick savings cushion households built up during the pandemic. The upturn in personal spending in October was supported by a drop in the saving rate to the second lowest level on record (2.3%). Though shrinking rapidly due to high inflation, this cushion is still around $1.8 trillion or 10% of disposable income. At recent rates of decline, it could last another year.

Also adding durability is the sharp pullback in oil prices. Gasoline costs have plunged 30% from all-time highs of just over $5.00 a gallon in June to $3.45 today, leaving a few extra dollars in people’s pockets and reducing a key threat to the inflation and rate outlooks. However, higher heating bills this winter are a reminder that inflation is still draining spending power.

And now the bad news: most historical recession markers still signal a downturn. One of the most reliable is the yield curve. Every U.S. recession since at least the mid-1970s (apart from the pandemic-led downturn) was preceded by a sustained inversion of the curve (Chart 2). It may have taken a year or two after the initial inversion, but the economy always contracted. With the yield on a 10-year Treasury note currently 77 bps below the 2-year issue, the negative gap is the widest since 1981. Leveraging the curve’s stellar track record, the Fed’s recession equation—based on the spread between the implied forward 3-month Treasury bill rate 18-months ahead and the current 3-month bill rate—puts the odds of a downturn in the year ahead at about 60% (Chart 3). This means the market sees a reasonable chance of the Fed reversing gears next year largely in response to a downturn. Similar odds occurred during the mid-1990s tightening campaign, when 300 bps of rate hikes inside a year nearly cut the expansion short. However, unlike today, the 10s-2s curve remained positive in that cycle.

Leading economic indicators almost always fall before a recession—you need to go back to the early 1960s for an exception (Chart 4). The current string of eight straight declines is sending a clear shot across the expansion’s bow.

Higher borrowing costs, lower equity and home prices, and a stronger dollar have hammered financial conditions. Our in-house measure suggests the weaker conditions will carve about 2 ppts from GDP growth in 2023 (Chart 5). This should suffice to tip the economy into a mild downturn, given that potential growth is just less than 2%.

So, most recession signals remain ominous. Earlier work in our department found that, looking back six decades, the Fed has never pulled off a so-called “soft landing” when starting from a position of high inflation and low policy and jobless rates. It might have better luck this time, but the odds aren’t great.

Bottom Line: Unless inflation recedes quickly, the U.S. economy still appears headed for some trouble, though possibly a little later than expected. The relative good news is that the downturn should be tempered by extra savings. But this assumes the economy’s durability doesn’t compel the Fed to slam the brakes even harder, in which case a delayed downturn might only flag a deeper one.