Mon, May 9, 2022

Although Recession is Unlikely in 2022, Risks Rise Further Down the Line

The easiest question to answer about the global economy these days is whether the United States is going to go into a recession. The obvious answer? Yes. The tougher question is when and how it will happen.

Over the past month, there has been a flurry of downward revisions to growth forecasts for the U.S., with a few economists baking a U.S. recession into their forecast for this year. There is also a lot of bad economic news globally amid what is likely to be aggressive tightening by the U.S. Federal Reserve. But calls for an imminent recession are too pessimistic–a sustained downturn is unlikely in the next 12 months, but the risks rise in the 12 months after that.

Talk of a U.S. recession kicked off when the yield on two-year treasuries dipped below that for ten-year treasuries (a so-called yield curve inversion) for 23 seconds on March 26. The yield curve has historically been a far more accurate predictor of a recession than any macroeconomist. In normal times, it slopes up and to the right to reward investors for locking up their money for longer. But if investors think the economy is about to go into recession, they demand a higher premium for holding short-term bonds than longer-term debt, and the curve inverts. Similarly, if the Fed is hiking interest rates, yields rise at the short end of the yield curve. But expectations for inflation over the long-term fall (on the basis that the Fed will keep inflation near its 2% average target) and with it the yield at the long end of the curve (determined by expectations for short-term rates, inflation and the term premium).

While we shouldn’t ignore a yield curve inversion, we shouldn’t consider it gospel, either. The yield curve has inverted without a downturn previously, and offers no insights into choreography or timing of a recession. Furthermore, financial–not economic–factors may have caused this part of the yield curve to invert in March. The U.S. Treasury is borrowing significant amounts at the short end of the curve to finance spending, pushing 2-year yields up. The Fed has been buying long-term treasuries through quantitative easing, pushing 10-year yields down. None of this offers any commentary on the likelihood of a recession.

Furthermore, the Fed argues that the 2-10 year spread is the wrong part of the yield curve to examine; the near-term forward spread (the expected three-month treasury yield eighteen months in the future minus the current three-month treasury rate) is a better predictor of a downturn. This part of the yield curve has been steepening for months, even as the 2s/10s curve inverted.

In addition to the yield curve, there have been some warning signs in the economic data as well. The U.S. GDP report for the first quarter was surprisingly weak, showing the economy contracted by 1.4% in the first quarter of 2022 (on an annualized basis). But this headline figure masks some important underlying strengths. Real final sales to domestic purchasers rose 2.6% year-on-year, up from 1.7% in Q4 2021. Consumer spending was up 2.7%, which was relatively strong given Omicron’s spread in January and February. Business spending–fixed, non-residential investment–grew a robust 9.2%, a sign companies are starting to invest to meet elevated demand.

The real weakness in Q1 GDP stemmed from a surge in imports as many goods were caught in supply chain snarls in the first quarter. At the same, time exports were tepid given weak European demand as incomes were squeezed by higher energy costs and a collapse in sentiment after Russia invaded Ukraine and COVID-19-driven lockdowns in China resumed. Inventories also grew at a slower pace than the major Q4 buildup. Tightening financial conditions and a significant fiscal drag were also headwinds for growth, with the latter shaving 3 percentage points off of GDP in Q1.

For those economists predicting a recession, the trigger is universal: the Fed. As inflation ticked up last year, the Fed argued that the impetus for higher prices was “transitory” and that they should look through accelerated inflation. By the end of last year, there were nascent signs that some supply issues were abating: order backlogs and supplier delivery times eased and the labor force participation rate ticked up, suggesting the labor supply constraints were improving as well. But the Russian invasion of Ukraine and Chinese lockdowns have exacerbated supply issues, keeping inflation elevated. In April, the PCE index (the Fed’s preferred metric of inflation) rose 6.6% year-on-year, the highest since 1982.

With inflation elevated but no good monetary policy tools to address supply side issues, the Fed must now engage in aggregate demand management to bring down prices, which necessarily means killing off demand. The central bank will hike rates aggressively this year, with some members of The Federal Open Market Committee (FOMC) indicating they are in favor of the policy rate reaching neutral (above 2.4%) by the end of 2022.

The Fed’s record on engineering a soft landing is lackluster; most of the Fed’s rate hiking cycles in the past have resulted in recession. Of the three times the Fed managed to engineer a soft landing, the cycle began with much higher unemployment. With unemployment at only 3.6%, it is difficult to imagine the Fed hiking rates aggressively without unemployment ticking up. As the Sahm Indicator suggests, an uptick in unemployment is the best indicator of a recession. The Fed has an impossible task, like trying to thread a needle while blindfolded and wearing oven mitts.

So far, the Sahm indicator remains far away from hitting the trigger for a recession (0.5 percentage points). The U.S. labor market continues to tighten, with the ratio of job openings to unemployment ticking up well above the pre-pandemic trend. While the Fed is likely to eventually push the economy into recession, we are still a long way from that point.

Unlike the last time the Fed hiked rates and shrunk its balance sheet, the U.S. central bank is joined by a number of other major central banks–the European Central Bank, Bank of Canada and Bank of England–in withdrawing accommodation as well. The Bank of Japan and the People’s Bank of China remain the only major central banks still in easing mode. This global coordinated withdrawal of liquidity as prices soar and global growth falters could cause market dislocations. And the impact of the Fed shrinking its balance sheet on growth and inflation is very poorly understood, so the process could be bumpy.

Volatility will remain elevated over the next twelve months, and both U.S. and global growth will decelerate significantly. But barring a vaccine resistant strain of COVID, chemical or nuclear war in Europe or another black swan event, a recession this year is unlikely.

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