A recession in the US?
The inflation data over the coming six months will be critical
Last month Deutsche Bank (DB) became the first major investment bank to predict an outright recession in the US by the end of 2023. The bank expects the European Union to follow suit in 2024. While other investment banks are now raising the probability of a US recession, DB remains the only one with a US recession as its base case.
Given that it is at one end of the spectrum, and its position has not yet been fully discounted by markets, it is worth examining the rationale of the DB argument. Economists at DB have also recently come out with another report outlining the downside risks to their already bearish view. They are convinced that all the risks to their recession call in 2023 are skewed to the downside and the report makes for scary reading.
They basically make the point that inflation will be far higher and stickier than what most market participants expect. Therefore, to break the inflation cycle, rates will have to rise much faster and higher than what most market participants anticipate and this will trigger a recession. They do not buy the soft landing argument and think that very tight employment data and strong consumer balance sheets will actually force the Federal Reserve to tighten by more to slow the economy and curtail demand. Strong consumer balance sheets make the task of slowing the economy to control inflation more difficult.
On why inflation will continue to surprise to the upside, they make the following points. First of all, several structural disinflationary forces have begun to reverse, be it globalisation, demographics and the cost of production in China or the need for higher cost alternative energy to tackle climate change.
Second, inflation is now being driven by rising costs, as strong demand comes up against a creaky supply chain that is unable to deliver on time, in the quantity needed. The labour market is hyper tight and will only worsen in 2022, as some of the labour supply disruptions seem structural. This implies that wage inflation, already higher than levels consistent with the Fed’s inflation objective, will only accelerate further. Rental costs will also accelerate as they still have a long way to go to catch up with surging property values.
Third, inflation psychology has shifted. Markets are getting used to seeing 7-8 per cent inflation prints across the world. Despite surging costs, corporate profits are doing fine, implying that the costs are being passed through and accepted by end buyers. Price increases are not getting pushed back.
Fourth, while longer-term inflation expectations have till now been restrained, they are rising. Inflation expectations are cyclical and heavily influenced by your most recent experience. If inflation were to remain elevated, there is a good chance expectations will also rise and create further pressure on the Fed.
Contrary to most other banks, DB expects core personal consumption expenditures inflation ( Fed favoured metric) to remain between 4 and 5 per cent throughout 2022 and 2023, compared to the current reading of 5.2 per cent. The Fed and all market players were caught flat-footed by the surge in inflation, and their belief in it being transitory; their models did not work. It will not be surprising that these same models, predicting inflation would fade over the coming months once again are inaccurate.
While commodity inflation will cool given the base effects, other costs may swamp it. This is the first plank of the recession argument.
The second plank is the belief that the Fed is much more behind the curve than most people realise. DB has created what they call a Fed misery index, tracking the percentage points inflation is above target currently and the percentage points the current unemployment rate is below the non-accelerating inflation rate of unemployment. On this measure, the Fed has a serious problem. The last time the Fed misery index was this high was in 1980, implying that the Fed has not been this far behind the curve since that period. It is also obvious that once the misery index crosses a reading of 2, (current reading near 6) Fed tightening has to be more aggressive and recessions more severe. It is also obvious that the numerous soft landings chairman Jerome Powell is alluding to, mid-60s, mid80s and mid-90s where the Fed tightened but there was no recession, all occurred when the misery index was at zero. The argument against the soft landing thesis is that the Fed is just too far behind the curve. It has never been able to achieve a soft landing when it has had to bring inflation down and unemployment up by as much as is needed today. The type of aggressive policy action which is needed today to cool the economy will inevitably cause a recession. That is the history.
The third plank is the extent of tightening required. The DB team makes the point that in the first instance we have to see the Fed funds rate at a neutral setting, implying the real rate at least at zero, if not slightly positive (currently at [-] 6 per cent). While inflation will come down, rate hikes have to be far more aggressive to achieve neutrality. Their expectation, consistent with their outlook on inflation is that we will need to see the Fed funds rate near 5 per cent. Now this is in no one’s numbers, not even remotely close. Many people are arguing over whether the Fed funds rate can even get to 3 per cent. The rate at 5 per cent will cause sticker shock and create waves in all asset markets. The report further argues that just reaching neutrality will not be enough, and debates how much above neutral will the Fed have to take the rate to slow the economy. Arriving at an estimate of 100-200 basis points above neutral as being the ultimate target, the DB team makes a case for the Fed funds target reaching near 6 per cent. The report also argues for the 10year bond yield to hit between 4.5 and 5 per cent, as a combination of rising Fed funds rate, balance sheet contraction by the authorities and rising inflation expectations hit fixed income markets.
The scenarios outlined in the report are scary and will bring markets down further were they to come to pass. The critical assumption remains that inflation is much more embedded than the Fed or its models believe. If the folks at DB are right on this core assumption, their scenarios are internally consistent. The Fed will have to raise faster and by more than consensus, and this will tip the US economy into a recession sometime in the next 12-18 months.
Ultimately every policymaker will be data driven. The inflation data over the coming 6 months has never been more critical. Markets will key off these numbers. Let’s hope we all get a break and the numbers undershoot.