In our recently published secular outlook we argued that recession across DM economies was more likely than not over the next two years, reflecting the greater potential for geopolitical tumult, stubbornly high inflation, and central banks’ resolve to fight inflation first, raising the risk of financial accidents.
A month after publishing those views, they still ring true. If anything, several developments suggest that recession could hit sooner, and with a more prolonged contraction as a result of the starting conditions of elevated inflation that will limit the usual countercyclical policy response from central banks and fiscal authorities (think of a shallow L‐shape instead of the deep pandemic V‐shaped recession). Indeed, a multi‐quarter contraction in real GDP starting this year, followed by a period of below trend growth, is now our outlook across various developed markets, including the U.S. We see three reasons for some evolution in our view.
First, high frequency economic indicators have deteriorated, both in the U.S. and elsewhere. And although we don’t think developed market economies have entered recession yet, measures of real activity are clearly trending in that direction. Just last week, European purchasing manager surveys, which tend to lead the official government economic indicators, fell to a level that historically has been consistent with a contraction in real GDP growth. And while U.S. real GDP started to contract in the first quarter and various GDP tracking estimates point to another contraction in the second quarter, we suspect that the National Bureau of Economic Research (NBER) won’t eventually declare a U.S. contraction until later this year.
As an aside, in the U.S., the NBER – the formal arbiters of U.S. recession dating – uses a more comprehensive definition than the 2 sequential quarters of GDP contraction rule of thumb discussed by many economic commentators. In particular, the NBER looks for a “significant decline in economic activity” across various metrics – including real aggregate income and consumption, manufacturing and trade sales and industrial production, and employment based on both the household and establishment surveys. And so far, the evidence is mixed. Indeed, 4 out of the 6 indicators (real consumption, Current Population Survey (CPS) employment, real manufacturing and trade sales and IP) each posted small contractions on a month‐over‐month basis in May and/or June. And while payroll growth as reported by the establishment survey was strong, suggesting U.S. labor markets haven’t yet entered recession, other leading indicators of labor market conditions – unemployment insurance claims, the Conference Board survey of household perceptions of current labor market conditions (the so‐called “jobs plentiful vs. jobs hard to get” indicator), and the employment indicators underlying the purchasing manager indexes – all point to a future rise in the unemployment rate.
Second, inflationary supply shocks have been more acute than originally expected. Geopolitical tumult and the war in Ukraine have pushed Russia to greatly reduce oil and gas flows to the EU. Just last week, the Nord Stream pipeline, which delivers Russian gas to Germany, was restarted after a maintenance period at only 40% of the pipeline’s capacity and, as of the time of this writing, was further cut to 20% of capacity after reported delays in the receipt of a turbine due to Western sanctions. According to our analysts, the lower flows are expected to continue, likely resulting in either (1) mandatory gas rationing schemes in Germany and other eastern European countries that are highly reliant on Russian gas, and/or (2) a relaxation of regulated utilities’ price controls which could achieve sufficient demand destruction through higher prices. Since gas is used to power factories in Germany and across the EU, higher prices and rationing, particularly on companies within the energy intensive chemical industry, will further raise input costs and slow economic activity across the supply chain.
The IMF estimates that a full Russian gas shut‐off from mid‐July could shave more than 2 percentage points off European GDP with harsher effects in countries with greater reliance on Russian gas. While we expect the status quo of the current 40% of pipeline capacity gas flows to be maintained, Europe still appears poised to enter into an inflationary recession later this year. Just as worryingly, due to the interconnectivity of global supply chains, the European supply shock will be felt in the U.S., which delivers 30% of its exports to Europe while relying on EU producers for 25% of imports, as well as the rest of the world. While some import substitution away from Europe will mitigate the effects on the rest of the world (China is mostly likely to benefit), industries including autos, which were already suffering from acute capacity constraints, will almost certainly have to manage further input product delays and higher costs.
Third, inflation is, more generally, proving more persistent, implying central banks may need to engineer recessions (not just a period of below trend growth) to restore price stability. This appears especially true in the U.S., where Fed officials have hinted that restrictive monetary policy is necessary. Indeed, although headline inflation will move lower over the coming months due to the recent decline in global oil and agricultural prices, wage (e.g., see the Atlanta Fed measure) and rental market inflation – two areas where price trends tend to be more persistent – have actually accelerated. More concerning, inflation has more generally accelerated in the face of slowing growth and tighter financial conditions, suggesting that more monetary tightening may be needed to restore price stability.
What are the broader implications? Starting conditions of elevated inflation mean the contours of this recession are likely to look very different than what we’ve experienced in the recent past. Elevated inflation will likely limit the usual countercyclical policy response from central banks and the fiscal authorities (with the caveat that various European governments are looking for ways to subsidize higher energy costs for low income households), contribute to higher interest rates, and more generally require tighter financial conditions to restore price stability. All of this suggests that the contraction itself could be slower moving, yet more prolonged, and is more likely to give way to a period of sluggish below trend growth, where real activity remains constrained and vulnerable to economic shocks until inflation finally moderates. Needless to say this isn’t a good environment for financial assets, and over the medium term elevated financing costs could limit the types of investments necessary to alleviate capacity constraints. Turning to the near‐term implications for this week’s FOMC meeting, despite elevated recession risks, Fed officials signaled another 75 bp rate is likely, and we wouldn’t rule out a larger adjustment.
While there is good deal of uncertainty around the exact level of the fed funds rate that is consistent with neutral policy (i.e., policy that is neither restrictive nor accommodative), what is clear is the current level of 1.6% is still accommodative, and that is increasingly out of sync with elevated inflation, which calls for restrictive policy. Indeed, the most prudent policy may require quickly adjusting financial conditions (i.e., a 100 bp hike to bring the policy rate to just above 2.5%, the Fed’s estimate of the long‐run neutral rate) to a level that addresses the risk that even higher rates may be necessary to address the current inflation problem. Still, regardless of what is ultimately decided this week, we expect the Fed will revise up their 2022 fed funds rate projections when the new SEP is released in September, by pulling forward the two hikes that were previously forecasted for 2023, thus holding policy restrictive sooner and for longer than previously forecasted.