23 May 2022 Economics & Growth | Monetary Policy & Inflation | US

Four Reasons for a 2023 Recession

Summary

The Federal Reserve is trying to lower inflation without causing a recession, but we think it will fail.
Here are four reasons to expect a recession in 2023:
- The economy’s demand side must shrink to align with the supply side.
- The Fed is already too far behind the curve.
- It is overestimating the strength of the labour market.
- Its policy instruments are blunt.

Market Implications

Stocks and bonds have already suffered considerable drawdowns since the Fed’s first 50bp hike on 3-4 May. But we expect further downside.

#1 Supply Has Shrunk, So Demand Must Shrink Too

The supply side of the economy has shrunk, and monetary policy must lower demand in line with supply to curb inflation.

Two indicators provide a rough sense of the cost pressures and supply-demand imbalances: the Producer Price Index (PPI) and the trade balance (Chart 1).

Current PPI inflation, i.e., the cost of producing goods, aligns with that of the second oil shock of the late 1970s. Also, the trade balance – the difference between the country’s imports and exports – relative to GDP is near the all-time low of 2005; excluding oil, it is the lowest ever.

Recessions followed both the second oil shock and the 2005 trade balance low.

#2 The Fed Is Already Too Far Behind the Curve for a Soft Landing

Since 1965, there have been 11 tightening cycles, plus the current one (Chart 2). Only three have not been followed by a recession.

The first was September 1965 to November 1966. But that one failed to stabilize inflation, meaning the Fed had to start another tightening cycle a year later.

The second was February 1983 to August 1984. Yet the increase in interest rates reflected more the Fed’s operating framework then than policy tightening, which was limited. Most importantly, inflation was already falling, and the economy had strong momentum due to the end of the July 1981-November 1982 recession.

The third tightening cycle to escape a subsequent recession was December 1993 to April 1995. This is likely the only genuine instance of a soft landing since 1965. However, the Fed started tightening proactively: the December 1993 unemployment rate was 1% above its long-term value, and core PCE YoY was 2.5%. In January 1994, it fell to 2.2%.

Chart 3 shows this by the small gap between the actual federal funds rate (FFR) and the Taylor rule FFR, the latter being a rule of thumb for the level of FFR needed to stabilize inflation. The so called ‘perfect’ soft landing cycle started with near-perfect initial conditions.

Now, though, the gap is huge, suggesting a soft landing is unlikely. That is, the Fed is already too far behind the curve.

#3 The Fed Overestimates Labour Market Strength

The labour market stat Fed officials cite most often as evidence of the labour market’s ‘extreme strength’ is the JOLTS ratio of vacancies to unemployed. But that ratio contains a lot of noise (indeed, it hardly correlates with wage growth).

Also, Fed officials are overlooking another, equally important ratio: the number of actual hires relative to advertised vacancies. That figure is at a historical low – employers are advertising jobs but not actually hiring (Chart 4).

This data suggests that the so called ‘excess’ demand for labour could prove fickle once the economy starts to slow. In this context, the Fed’s unswerving focus on the vacancies to unemployment ratio is adding downside risks to the economy.

#4 Monetary Policy Is a Blunt Instrument

For years, the Fed acted on the belief that raising inflation was harder than lowering it. But lowering inflation could prove trickier than the Fed expects.

As mentioned above, the Fed must lower demand to align with weakened supply. And the main lever for monetary policy could be to raise the funding cost of residential real estate and consumer durables – the two interest-sensitive components of aggregate demand. In real terms, however, interest rates remain at or near historical lows (Chart 5).

In the residential real estate market, house prices are growing at almost a 20% annual rate against the benchmark 30-year mortgage rate at 5.3%. Inventories are low. And even if demand slows, it will take time for inventories – and prices – to return to historical norms. Similarly, excess demand for consumer durables could keep prices high even after significant Fed tightening.

The current cushion of excess demand will make calibrating policy harder than in a more run-of-the-mill hiking cycle, which adds to the risk of hard landing.