Nomura wakes in fright. My only issue with this analysis is that it may still be too slow, inflation will bust faster and rates not get so high.
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With rapidly slowing growth momentum and a Fed committed to restoring price stability, Nomura believes a mild recession starting in Q4 2022 is now more likely than not (ZH: expect the mood to deteriorate further as “mild” eventually becomes “jarring”).
Financial conditions are likely to tighten further, consumers are experiencing a significant negative sentiment shock, energy and food supply disruptions have worsened and the outlook for foreign growth has deteriorated. All these factors will likely contribute to the expected downturn.
Relative to previous downturns, Nomura believes that the significant strength of consumer balance sheets and excess savings should mitigate the speed of the initial contraction. However, policymakers’ hands are tied by persistently high inflation, limiting any initial support from monetary or fiscal stimulus.
The bank lowered its real GDP growth forecast in 2022 to 1.8% y-o-y (-0.3% Q4/Q4), down from 2.5% (1.4% Q4/Q4). In 2023, it expects real GDP to decline 1.0% y-o-y (-1.2% Q4/Q4), down from +1.3% (+0.6% Q4/Q4).
The bank also expects the unemployment rate to rise to 5.2% by end-2023 and 5.9% by end- 2024, above previous expectation of a rise to 4.3% over that period.
For inflation, the near-term impact of the bank’s economic outlook revision is more muted considering the persistent nature of rent inflation and rising inflation expectations. Nomura only lowered its Q4/Q4 2022 core PCE inflation forecast 0.1% to 4.4%, largely reflecting core goods prices. However, the Q4/Q4 2023 core PCE inflation forecast now stands at 2.4%, down from 2.8% previously.
With monthly inflation through 2022 likely to remain elevated, Nomura economists believe the Fed response to the downturn will initially be muted, and expect ongoing rate hikes to continue into 2023, but with a slightly lower terminal rate of 3.50-3.75% reached in February (down from our previous forecast of 3.75-4.00% in March). However, it now expects rate cuts in H2 2023, lowering the funds rate to 2.875% by end-2023 and 0.875% by end-2024.
Factors driving the downturn
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The persistence of inflation and a single-mandate Fed
From a very high level, the ongoing persistence of elevated inflation and growing evidence of unanchored inflation expectations are the two key drivers of our expected growth downturn. Despite the Fed’s significant hawkish pivot since November 2021, inflationary pressures have not eased meaningfully and may have arguably worsened (Fig. 2 ). Inflation expectations are showing growing signs of being unanchored (Fig. 3 ). Against that backdrop, we believe the Fed’s efforts to realign demand with depressed supply to rein in price pressures will ultimately drive the economy into a mild recession.
Recent financial conditions developments and their implications for growth
Financial conditions have tightened considerably in 2022, but not yet to levels that would suggest a significant drag on growth. Broad measures of equity prices have declined between 20-30% and BBB option-adjusted corporate credit spreads have widened over 60bp. While NFIB’s latest data suggest small businesses are not yet experiencing a material deterioration in credit conditions, that could soon change. Altogether, our financial conditions index has moved lower – implying a roughly neutral impulse to growth after hovering around 3pp in late 2021 – but has not yet entered negative territory (Fig. 4 ).
Interest-rate sensitive GDP components
Within the real economy, interest-rate sensitive GDP components are likely to accelerate the downturn. Already, housing demand has shown signs of pronounced weakness as both existing and new home sales move lower and starts and permits lose steam. The sensitivity of US GDP growth to higher interest rates could be larger in this cycle, considering interest rate-sensitive components comprise a historically elevated share of real GDP (fig 5).
Durable goods consumption jumped sharply above its recent trend during the pandemic, due to constrained service activity and significant policy support. With rapidly rising interest rates, and deteriorating economic conditions, the pullback in durable goods spending in 2022 and 2023 will likely result in a larger-than-usual negative impulse to growth. In particular, to some degree, durable goods consumption and home sales are interconnected and the recent deterioration in home affordability could weigh on durable goods consumption significantly (Fig. 6 ).
Rapid home price growth during the pandemic has pushed up the home price-to-rent ratio to levels not seen since the early 2000s (Fig. 7 ). Despite the lag with which home prices will likely respond to the downturn, we see elevated risk of price corrections, which could prolong the downturn. Moreover, if workers lose bargaining power for remote work opportunities as the unemployment rate rises, COVID-related migration could reverse, which may exert downward pressure on home prices in areas that benefitted from the shift in work conditions
Consumers are experiencing a sentiment shock
For much of 2022, we have expected strong service consumption – due to re-opening, pent-up demand and excess savings – to support overall consumer spending despite headwinds for goods consumption. However, in recent months, meaningful signs of a negative consumer sentiment shock have emerged. Google search activity for “recession” has increased above levels that prevailed during the Global Financial Crisis (GFC) and the University of Michigan’s consumer sentiment index dropped to its lowest level on record in June (Fig. 8 and Fig. 9 ).
In May, real core retail sales declined notably, but real food services spending also faltered, suggesting a growing risk the expected rotation to services to offset weakness in goods may already be unraveling. The Fed intends to materially slow demand to rein in inflation, and continued elevated employment growth in that context seems increasingly unlikely. Indeed, as evidenced by the June Summary of Economic Projections (SEP), the Fed’s efforts are increasingly designed to push up the unemployment rate over the forecast horizon to lower inflation by reducing labor market tightness.
Commodity price shocks risk becoming the new normal
In addition to tighter financial conditions, the exposure of interest-rate sensitive sectors and a consumer sentiment shock, the outlook for supply shocks – particularly for energy and food – has continued to deteriorate this year. The ongoing Russia-Ukraine war and its impact on global commodity markets and supply chains has shown few signs of improvement, and may have started to become more entrenched. After commencing 2022 around $75/barrel and spiking to as high as $123/barrel at the onset of the war, WTI crude oil prices have remained persistently high, averaging close to $120/barrel during June. Retail gasoline prices in the US have risen sharply and persistently from around $3.30/gallon at end-2021 to over $5.00/gallon in June. Increased demand from the ongoing reopening of China after Omicron-linked lockdowns suggests further upside risk to energy prices.
Policy support will be on the sidelines
One of the most significant differences between our expectation for this recession and prior episodes involves the response from policymakers. In the current high-inflation environment, both monetary and fiscal policy are likely to be much more restrained in their response relative to previous recessions.
The Fed’s hands are likely to be tied through 2022 by elevated inflation
Fed officials have been clear they will prioritize restoring price stability above all else. Unfortunately, we believe monthly core inflation is likely to remain quite elevated and above levels with which the Fed would be comfortable, at least through 2022, and likely into early 2023.
As shown inFig. 2, the main driver of elevated trend inflation pressures continues to be owners’ equivalent rent (OER) inflation – one of the largest, and “stickiest,” inflation components. Due to BLS methodological differences and the lead-lag relationship with shelter prices and the economic cycle we do not expect OER inflation to meaningfully improve until early 2023. As a result, the Fed is likely to downshift to a 50bp rate hike in September, and 25bp per meeting thereafter before holding rates at an elevated rate. However, we do not expect any signs of potential easing from the FOMC, i.e., rate cuts or QE, in the near term.
Over the past decade and a half, the proximity of the Fed’s policy rate to the effective lower bound (ELB) has helped establish a standard “playbook” for responding to recessions, exemplified during the COVID crisis: cut rates swiftly and sharply to the ELBand prepare for large scale asset purchases (LSAPs, or QE), in order to provide additional accommodation.
That playbook is likely to be of little use to policymakers in the current environment, due to persistently elevated inflation. While we expect rate cuts to start in H2 2023, they will likely come much later than they otherwise would have absent strong inflationary pressures. Moreover, the pace of rate cuts is likely to be slower than in previous recessions (Fig. 16). We believe the Fed will continue to reduce the size of its balance sheet into 2023considering its historically elevated size and their plans to tighten financial conditions beyond raising short-term rates. Both actions run against what policymakers would likely prefer to do in a standard recession.
Fiscal policy support is likely to be absent, or outright restrictive
Similar to monetary policy, we believe fiscal policy will largely remain on the sidelines for the expected recession, aside from the regular impact of automatic stabilizers like unemployment insurance. Policymakers in Washington across the spectrum have increasingly taken the view that significant, and unprecedented, fiscal support during the pandemic helped exacerbate inflationary pressures. That experience, combined with widespread voter dissatisfaction due to inflation, will make many members of Congress reluctant to provide any kind of discretionary fiscal stimulus. One of the most striking indications of just how quickly the conversation in Washington has changed has been recent commentary from Biden administration officials on the potential for deficit reduction to help combat inflation. Treasury Secretary Yellen in particular has suggested deficit reduction could help address elevated inflation pressures.
With our expectation of a return to divided government after the November 2022 mid term elections – we believe Republicans are likely to take back both the House and the Senate– Washington will likely return to gridlock. Republicans face few incentives to collaborate with the Biden administration with an important presidential election looming in 2024. Moreover, Republicans may be emboldened during debt limit and regular appropriations debates to push for outright spending cuts, which could exacerbate the recession in 2023.
Putting everything together
We expect a modest recession to start in Q4 2022
Combining the factors above, we expect a modest recession to start in Q4 2022 (Fig. 17). Relative to previous downturns, we expect a shallower and longer path, for three reasons. First, as noted above, robust consumer balance sheets and excess savings should limit how quickly growth decelerates. Second, the lack of policy support – monetary and fiscal– at the onset of the recession will likely prolong its length. Third, despite some concerns over corporate debt, there is no obvious financial accelerator to amplify the recession shocks like the GFC (Fig. 18).
In terms of annual changes, we lowered our real GDP growth forecast in 2022 to 1.8% y-o-y (-0.3% Q4/Q4), down from 2.5% (1.4% Q4/Q4). In 2023, we expect real GDP todecline 1.0% y-o-y (-1.2% Q4/Q4), down from +1.3% (+0.6% Q4/Q4).
The unemployment rate will likely rise to around 6%
We expect nonfarm payroll employment growth to begin decelerating, but not as quickly as overall growth. Labor demand remains elevated and some firms may engage in labor hording during the initial stages of the downturn, resulting in weak productivity growth.NFP is likely to start declining in February 2023 under our base case. The unemployment rate will likely rise from an expected trough of 3.3% in the next few months to 3.5% by end-2022, 5.2% by end-2023 and 5.9% by end-2024. Our unemployment rate trajectory is less severe relative to the GFC, but slightly higher than 2001, reflecting less initial policy support (Fig. 19).
Our updated outlook for inflation
Inflationary pressures remain strong and, due to a number of reasons, we think the economic downturn we expect may not exert substantial near-term disinflationary shocks, resulting in only modest revisions to our inflation forecast. First, supply constrains will likely continue to help prices remain at elevated levels. We have started to observe some encouraging signs of inflationary imbalances easing in certain goods prices, such as home appliances and furniture, motivating us to lower our forecast for core goods prices modestly. However, vehicle prices, determined by complex supply chains, continued to increase. We believe it will take time to meet accumulated pent-up demand for vehicles, even if auto production picks up. As a result, we expect core goods prices to continue to make a positive contribution to core PCE inflation on a y-o-y basis until mid-2023 (Fig. 20).
Our expectations for the Fed’s reaction function
Little impact on our near-term Fed call as the Fed remains “all in” on restoring price stability
We believe the Fed remains committed to ensuring inflation returns to 2% sustainably. With inflation remaining much too high, as Governor Waller noted over the weekend, theFed remains “all in” on restoring price stability. As noted above, inflation concern will likely outweigh the muscle memory from prior cycles of rapidly easing financial conditions at the onset of the downturn. For this downturn, the Fed’s expected reluctance to ease policy is likely to be one of the driving factors. Monthly core inflation will likely remain elevated through 2022. As a result, we have not changed our near-term Fed call: we continue to expect 75bp in July, 50bp in September and 25bp in November and December, bringing the policy rate up to 3.25-3.50% by end-2022.
We expect a slightly lower terminal rate in 2023 and earlier rate cuts
However, 2023 has become somewhat more uncertain. As the recession worsens, the Fed may gain confidence that a higher unemployment rate and weaker overall demand will bring inflation lower. As a result, we expect the Fed to stop hiking after another 25bp in February, implying a slightly lower and earlier terminal rate forecast of 3.50-3.75% (3.75-4.00% in March 2023 previously).In addition, while we believe the Fed will hold rates at a restrictive level for several months as annual inflation remains elevated, we expect the Fed to begin cutting rates somewhat earlier, in September 2023 instead of early 2024. Higher unemployment and weaker growth should increase confidence that inflation will sustainably return to 2%. As a result,we believe the Fed will lower rates by 25bp per meeting starting in September, resulting in an end-2023 fed funds rate of 2.875% and end-2024 of 0.875%.Fig. 25shows our updated forecast for the Fed’s policy rate.
Balance sheet normalization will likely end earlier in 2023, and we no longer expect MBS sales
In terms of balance sheet policy, we believe the Fed will not engage in MBS sales as the US economy enters a recession, especially as we expect rapidly worsening housing market conditions. As a result, we no longer expect MBS sales to begin in January 2023.We expect the Fed will continue balance sheet normalization during most of 2023. However, we brought forward the expected end to balance sheet normalization to end-September 2023 from end-December 2023 previously, considering the Fed will likely prevent rate and balance sheet policies from operating at cross purposes.
Adjusting our outlook for Treasury yields
Considering the short end of the curve’s sensitivity to the Fed’s policy decisions and the long-end’s sensitivity to growth concerns, we expect the 2s10s curve to invert in Q3 2022and remain inverted through Q3 2023. However, the overall level of the curve should shift lower throughout the forecast horizon as the market starts to reflect more aggressive rate cuts in 2023. As a result, we lowered our year-end 10yr rates forecast for 2022 and 2023to 2.65% and 1.70%, respectively, from 3.10% and 3.05%
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
