According to Deutsche Bank, it is coming in a little over a year. My personal view is it will arrive sooner, beginning sometime later this year overseas and in 2023 in Australia. My own view is also that it will take fewer rate hikes. At this point, that’s not terribly important. The strong base case is that it is coming.
Today, DB’s Head of Research and Chief Economist David Folkerts-Landau has published an important piece alongside Peter Hooper and myself. Early last summer we launched our “What’s in the tails?” series to express views that were different to the House View. In our first paper, we argued that higher inflation was going to be the defining macro story of the decade. In this new paper, we discuss how Fed Funds and the ECB rate will likely have to go higher than the consensus believes and that, as a consequence, the upcoming recession will be more severe than even our outlier House view forecast.
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Indeed it surprises us that of the 75 professional forecasters on Bloomberg our House view is the only one currently predicting a US recession by the end of 2023. Given the macro starting point, our view is that the burden of proof should be on why this boom/bust cycle won’t end in a recession.
Talking of the macro starting point, one way we articulated this in the piece is using our US economist Matt Luzzetti’s so called “Fed Misery Index”. This shows the sum of the amount (in percentage points) by which inflation exceeds the Fed’s 2% target objective plus the amount (in percentage points of unemployment) by which the labour market is estimated to have tightened beyond its sustainable full employment level.
It is noteworthy that in the past, every time this index has moved noticeably above zero, the economy has gone into recession within a few years as a result of monetary tightening. On this basis, the Fed is currently much further behind the curve than it has been since the early 1980s. In the past, higher levels of the index(as we are seeing now) have tended to be followed by more aggressive Fed tightening and more severe recessions. It’s also interesting that the successful“soft landings” achieved by the Fed cited by Chair Powell – that’s the tightening episodes in the mid-60s, mid-80s, and mid-90s that were not followed by recessions – occurred when the index was essentially at zero. Those were very different environments from the challenging one the Fed faces today, and the Fed was generally acting much more preemptively than it is now.
We are currently experiencing a paradigm shift in macroeconomics. Consensus forecasts, of which there is traditionally little deviation around, have been consistently wrong over the past decade or so and especially in the last couple of years. Forecasters underestimated the scale of the pandemic rebound, the inflationary impact of the stimulus packages, and the fact that it wasn’t transitory. Do we have a huge problem in the profession with models that are not fit for purpose? These same forecasters and models now expect us to believe there will be a soft landing from a starting point at which a soft landing has never been achieved. So while the official DB house view now forecasts a US recession in late 2023 / early 2024, and was the first bank to do so, I am verysurprised we are the extreme outlier on the street. Given the macro startingpoint, my view is that the burden of proof should be on why this boom/bustcycle won’t end in a recession.
We set up this “What’s in the tails?” series last June, encouraging our analysts to give an alternative to the official house view where we felt there was a well-reasoned and credible alternative scenario. In our first publication that month, I joined my colleagues Peter Hooper and Jim Reid to argue that higher inflation would be the defining macro story of the decade and that the consensus risked missing the paradigm shift. In this latest note in the series we outline how the macro risks are skewed heavily to the downside risk of a significant recession.
In short, the scourge of inflation has returned and is here to stay. While we may have seen the highs now, it will be a long time before it recedes back to acceptable levels near the Fed’s 2% target. As a society, monetary tightening is a policy that affects all of us; and it is sorely tempting to take a go slow approach hoping that the US economy can be landed softly onto a sustainable path. This will not happen. Our view is that the only way to minimize the economic, financial, and societal damage of prolonged inflation is to err on the side of doing too much. The labor market and household balance sheets are strong, and the only way to push down aggregate demand is to raise rates higher and faster than might seem reasonable. Thinking back to the early Volcker years we ask ourselves whether the massive increase in rates would be viewed today as being over the top under similar circumstances. Probably, but they were proved necessary. Like then we will get a major recession, but our strongly held view is that the sooner and the more aggressively the Fed acts, the less longer-term damage to the economy there will be. Markets just need to be shown that theFed will do what is necessary and not tolerate prolonged inflation, even if it is“only” in single digits. The US is extremely fortunate in having an apolitical central bank that does what is right for the country even if that means an unavoidable recession.
Inflation has returned with a vengeance; forecasters were being forced rapidly to upgrade their projections even before Russia’s invasion of Ukraine, and the picture has clearly worsened since. In turn, investors and the Fed are now anticipating a much more aggressive path of monetary tightening. Our own street-leading House view has the fed funds rate going above 3.5% plus an additional 1/2%pt-equivalent tightening in the form of fed balance-sheet reduction. We also see the ECB raising
rates by 2.5%pts to deal with an inflation problem that is not far behind that in the US. This monetary tightening is enough to push the US economy into a mild recession by late next year and eventually—over several more years—bring inflation back to more desirable levels. We also see the euro area economy slowing to near recession rates in early 2024. 1
We find it remarkable that this House View recession call is at the pessimistic extreme of the range of 75 macroeconomic forecasters captured in the Bloomberg survey. To us, the risks to this outlook seem clearly skewed to the
downside—for a more severe recession. Our central message is that there are good reasons to expect inflation will continue to surprise to the upside and in its stubbornness to remain well above the policy targets. We regard it, therefore, as highly likely that the Fed will have to step on the brakes even more firmly, and a deeper recession will be needed to bring inflation to heel. What follows is an elaboration of these views.
Why consensus and market views are slow to see a recession ahead
We can see at least a couple of reasons for the slow uptake of recession calls by economic forecasters. First, the overheating of the economy has taken many by surprise. Market participants were heavily anchored by the experiences of the last decade. Much as generals have a tendency to fight the last war, so too do markets lean heavily on their experiences of the last cycle. But the aftermath of a historic financial crisis is not comparable to a global pandemic. We know from history that financial crises tend to have long recovery times, and our experiences from the 2010s were in line with that historic playbook. In contrast, the pandemic recession was not caused by excessive leverage but by enforced shutdowns alongside consumers’ personal fears of the virus which inhibited activity. So there was scope for a much quicker recovery once those impediments passed—especially when aggregate demand was supercharged by massive fiscal support packages.
Second, consensus and market views about inflation prospects have a strong mean-reverting component. As inflation has surprised increasingly to the upside, forecasters have nevertheless continued to see it returning to the Fed’s objective within a few years (Figure 1). There is ample faith that the Fed will achieve its objective, and as the Fed has been telling us, this can somehow be done without a significant economic slowdown or increase in unemployment. For now, both market-based and survey measures of longer term inflation expectations remain in the general vicinity of the Fed’s inflation objective, but as we will argue, that could soon change.
What drives our own view
The most important factor driving the view we present here is the likelihood that inflation will remain persistently elevated for longer than generally anticipated. Several developments will contribute to continued upward “surprises” in inflation:
n First, a number of the structural disinflationary forces that were prevalent in recent decades had begun to shift even before the Covid shock hit. These include a reversal of globalization, shifts in demographics in China, the US, and elsewhere, shifting trends in digital in an inflationary direction, and climate change. 2 As a result of these and other developments, underlying trends in inflation have shifted upwards significantly.
n Second, inflation is now being driven increasingly by rising costs, reflecting strong demand in the face of supply that has been struggling to keep up. The labor market is extremely tight and generally projected to tighten further this year, thanks in part to strong consumer-driven demand and in part to disruptions to labor supply that now seem likely to persist for some time. This means wage inflation, which is already running well above levels consistent with the Fed’s price inflation objective, will be rising further. Supply-chain disruptions that have lifted inflation for many key inputs into production are being exacerbated by the war in Ukraine as well as the Covid-driven disruption of activity in China. Rental costs will be accelerating further as rents still have a good ways to go to catch up with surging property values. Energy and other material costs have risen tremendously already, and while that is one area that could begin to work the other way as prices appear to have peaked, it will be swamped by rising costs elsewhere.
n Third, inflation psychology has shifted dramatically. Despite tremendous increases in costs, profits are doing very well. Sellers have been increasingly willing to pass cost increases along to their customers, and buyers are increasingly willing to absorb those price increases.
n Fourth, while longer-term inflation expectations may still be in the neighborhood of the Fed’s objective, they have generally been rising. More important, historical experience shows that these expectations are strongly influenced by what has been happening to actual inflation recently. Given the likely persistence of higher inflation in the near term, we can expect to see further significant increases in inflation expectations over the year ahead, and this will in turn support the continued elevation of actual inflation.
n Finally, policy measures taken by the Fed as currently envisioned by the markets and even our own more aggressive House view call will be slow to restrain inflation. With inflation remaining anywhere near current levels, the real fed funds rate will remain substantially negative and thereby fail to reach a “restrictive” level, even if balance sheet rundown does more to push up longer-term market rates. We could also note that much has been made of the so called “flattening” of the Phillips curve in recent decades—that is, the weakening of the link between unemployment and inflation, which is ultimately the Fed’s key lever over inflation.3
The bottom line is that while inflation may be reduced somewhat in the near term as commodity prices peak and base effects come through, momentum in labor costs, expectations, and other factors are likely to keep it elevated for some time.
We would not be surprised to see core PCE inflation (the Fed’s favored measure), which is now running above 5%, sustained in the 4-5% range well into 2023 before receding after the recession hits.
A summary indicator of how far behind the curve the Fed is now
In light of the above observations, it is generally accepted that the Fed has fallen significantly behind the curve and that substantial monetary restraint is now needed. To drive this point home, we adopt a quantitative measure introduced recently by our US Economics team that gauges how far the economy has strayed from the Fed’s mandates of price stability and maximum sustainable employment.
The index in Figure 2 below shows the sum of the amount (in percentage points) by which inflation exceeds the Fed’s 2% target objective plus the amount (in percentage points of unemployment) by which the labor market is estimated to have tightened beyond its sustainable full employment level.5 We have labeled this index the Fed’s “misery index,” given its similarity to the national misery index, which is simply the sum of inflation and unemployment.
Positive readings in the chart indicate that the Fed has work to do in a tightening direction: inflation is too high and or unemployment has moved too low to be consistent with stable inflation. It is noteworthy that in the past, every time this index has moved noticeably above zero, the economy has gone into recession within a few years as a result of monetary tightening. On this basis, the Fed is currently much further behind the curve than it has been since the early 1980s. In the past, higher levels of the index as we are seeing now, have tended to be followed by more aggressive Fed tightenings and more severe recessions. It is also of interest that the several successful “soft landings” achieved by the Fed that Chair Powell has cited recently—that is tightening episodes in the mid-60s, mid-80s, and mid-90s that were not followed by recessions–occurred when the index was essentially at zero. Those were very different environments from the challenging one the Fed faces today, and the Fed was generally acting much more preemptively than it is now.
How much will the Fed have to raise rates, and what will be the impact?
All this means the Fed now has a lot of work to do to catch up. Its first task is to get the fed funds rate back to neutral as quickly as possible. With inflation likely to be elevated well into next year (until the Fed succeeds in slowing things down), the neutral level of the Fed funds rate could well be in the vicinity of 5%. This allows for a modestly positive real fed funds rate in line with FOMC assumptions. It also assumes core PCE inflation will be running not far below 5% over the year ahead.
Next, policymakers will have to determine how far above neutral to go to slow the economy enough to bring inflation down. In recent business cycles, the Fed has gone a percentage point or less above neutral, as indicated by the “interest rate gap” in Figure 3 below, which equals the fed funds rate minus an estimate of its neutral level. 7 As we have noted, however, until very recently the Fed has been more preemptive in recent decades and has had to deal with much less severe levels of its misery index than previously. Facing higher levels of that index in the 1970s and 80s, the Fed moved quite a bit further above neutral, although in the 1970s, these moves were short-lived and insufficient to quell inflation. We assume conservatively that a fed funds rate moving well into the 5 to 6% range will be sufficient to do the job this time. This is partly because the monetary tightening process will be bolstered by Fed balance sheet reduction, which our US economics team estimates will be equivalent to a couple additional 25 bp rate hikes. We do still see upside risk to this estimate. If the Fed were to follow the prescription of a standard Taylor rule, for example, the fed funds rate could reach double digits.
In any event, we expect that the policy rate hikes, balance sheet reduction, and rising inflation expectations will raise the 10-year Treasury yield to a peak level in the vicinity of 4-1/2 to 5%.
The Eurozone faces similar but less severe risks. With European inflation potentially remaining well above 7% this year, the ECB would move the deposit rate to 2% a good deal sooner than our current House call of late 2023. This could yield a mild recession next year, with the 10-year Bund moving into the 2.5-3.5% range with substantial volatility.
Our basic message is that the fed funds rate and the ECB Deposit rate will have to go up significantly more than what is currently being forecast by these institutions if inflation is to be brought under control. In either case it is highly likely that the degree of monetary tightening needed will cause a significant recession. Once investors gain greater confidence and visibility on the inevitability of a recession, most likely next year, we expect significant down moves in equity and credit.
In sum, the inflation process has gained considerable momentum, especially in the US. It has broadened and is now being driven increasingly by an extremely tight labor market. Inflation psychology has shifted significantly in a direction that supports this momentum, and a self-reinforcing rise in inflation expectations is likely not far behind. Evidence of similar inflationary dynamics is beginning to emerge in the euro area. The Fed has been slow to catch up with these developments and finds itself both well behind the curve and with less leverage than in the past to deal with the problem. As it now shifts to a more aggressive tightening stance, the historical record tells us the Fed has never been able to correct even noticeably smaller overshoots of its inflation and employment objectives without pushing the economy into a significant recession. For these reasons, we see the risks of US recession–indeed of the severity of the recession to come–clearly weighted to the upside of consensus expectations. The ECB too may have to push rates higher than the market currently expects to cool the economy and damp the emergence of excessive inflation pressures.