I have for a long time been an optimist when it comes to the economy. When others argued in the years following the 2008 financial crisis that a
was nigh, I maintained an upbeat economic view. More recently, I’ve generally been positive during the pandemic – even during the depths of the lockdowns and as various government-support programs rolled off. However, I’m starting to change my outlook, and for several reasons, I now believe that a recession is more likely than not.
The Fed’s shifting tune
Let’s start with the most obvious issue for the economy: the Federal Reserve. The Fed is in the risk-management business – balancing the various threats to the long-term health of the US economy and adjusting its support accordingly. If the biggest threat is a slowing economy, it can lower interest rates and use its tools to add fuel to the financial system. If the threat is higher inflation, it can raise interest rates and slow the economy, cooling off prices in the process.
In recent years, low inflation and weak global growth meant that the Fed’s risk-management approach was tilted towards keeping interest rates low and stimulating the economy. Every time the markets or economy seemed to stumble, the Fed was there. Stock sell-off? A hiccup in the housing market? The Fed could be counted on to step in and provide the support. But today that calculus has shifted. It’s clear that the Fed chair Jerome Powell and other Fed officials believe that slowing down red-hot prices and lowering expectations for continued price growth is their most important task. They’ve launched an aggressive campaign of interest-rate hikes to get this problem under control and seem committed to the task – even if that means pushing the economy into a recession.
Just look at recent comments from Powell: “Is there a risk we would go too far? Certainly, there’s a risk. But the bigger risk is that we would fail to restore price stability.” Or a recent speech from the Cleveland Fed president, Loretta Mester, in which she argued that even in the face of a weakening economy, the Fed’s model showed that “the more costly error is assuming inflation expectations are anchored when they are not.” Mester’s last point on inflation expectations is important – the Fed is not just trying to tackle actual inflation but also prevent people’s expectations of future inflation from increasing. In the Fed’s opinion, if households expect higher prices in the future, they will be more likely to accept higher prices now, causing an ever-increasing cycle of inflation that is harder to break.
Assume the Fed can walk through two doors. Behind Door No. 1, the Fed raises interest rates enough to bring inflation down, but pushes the economy into recession in the process. Behind Door No. 2, the Fed fails to tighten enough and, as a result, inflation expectations increase. When faced with these two choices, the Fed is saying quite clearly that they’ll walk through door No. 1. A policy mistake that results in recession is preferable to the alternative – allowing inflation expectations to become unanchored.
A weakening environment
The Fed has been signaling an aggressive push to cool inflation for months, but the more worrying issue is that the commitment to these interest-rate hikes comes at a time when economic data should push them to do less.
Previously, I’ve argued that despite the Fed’s push to wrangle inflation, the economy was in a strong enough place to survive the rate hikes. But now the calculus has changed. The economy is not in recession right now, but the Fed can push it in this direction if it’s not careful.
In light of these issues, it’s clear the Fed’s outlook for the economy over the course of the year is too rosy. In the latest Summary of Economic Projections, the Fed’s estimate for 2022 GDP growth is 1.7%. But GDP growth for the first quarter was negative 1.6%, and the Atlanta Fed’s GDPNow estimate – which provides a real-time estimate of this quarter’s GDP growth – is sitting at negative 2.1% for the second quarter. Doing the math, the GDP would need to drastically rebound to more than 5% in the second half of 2022 to achieve the Fed’s full-year estimate. Anything is possible, but the more likely outcome is that the Fed will cut its GDP outlook again in September, even while planning more rate hikes. That’s not exactly a good signal.
Missing the inflation forest for the gas-price trees
So what would it take for the Fed to shift gears and move from inflation-fighting mode to recession prevention? Not to point out the obvious, but the first step would be a clear cooling off of inflation.
There are signs that this cool off is already happening. Look through any corporate earnings report and the evidence is obvious. Apparel retailers are talking about excess inventories. The rates businesses are paying to ship goods are coming down. Oil and other commodities prices have been dropping. Eventually, the cheaper costs for businesses will pass through to consumer prices.
Given these shifts, there’s a good chance core PCE inflation, the Fed’s preferred measure of inflation that strips out volatile categories like energy and food, ends up at or below the central bank’s current 2022 projection of 4.3%. Even headline inflation, which adds energy and food, could come down in the coming months as gas prices continue to decline. But the bigger issue is that it’s unclear whether good inflation data would be enough to get the Fed to ease up on their rate-hike plans.
At times, it feels like Powell cherry-picks indicators as rationalizations for moves he’s already decided to make. At his press conference in June, Powell specifically highlighted a single indicator as a big reason the Fed ramped up that month’s interest rate hike to 0.75%, after signaling for weeks that the hike was only going to be 0.5%. The five- to 10-year median-inflation-expectations outlook from the University of Michigan’s consumer confidence survey had jumped to 3.3%, breaking out of its recent steady range and pushing the Fed to worry that expectations were becoming unanchored. “So the preliminary Michigan reading, it’s a preliminary reading, it might be revised, nonetheless it was quite eye-catching and we noticed that,” Powell said. But the construction of the University of Michigan’s survey makes it somewhat less reliable than other measures of household-inflation expectations. And as to the “preliminary” aspect of the survey? Well, the final version of the survey that came out two weeks after Powell’s statements revised the number down to 3.1% – within the range from the past six months. Considering that longer-term household-inflation expectations are also highly influenced by high-frequency purchases like gasoline, there is some chance that this data point falls further in the month ahead.
Powell and other Fed officials have also thrown out a variety of other one-off indicators to back up their decision-making, but none of them form a coherent picture of what the Fed wants. This is a problem. The Fed has said it does not want to be a source of instability for the market, but this scattershot approach does not help.
Superman isn’t coming
So there is the formula for my pivot to worry: an increasingly hawkish Fed that is locked into an interest-rate-tightening campaign at a time when economic data – on both the demand and inflation side – suggests it should shift course. The Fed’s current path will reinforce weaker growth expectations and could eventually push the US into a recession.
The main risk for the financial markets and economy is as follows: There is a high bar for the Fed to pivot from its current policy track, but there is a relatively low bar for downward revisions to their projections for both economic growth and core inflation. Of course, there is a way to avoid this doom-and-gloom scenario: The Fed can pivot from its current path and demonstrate that it’s more data dependent than it’s currently letting on.
Neil Dutta is Head of Economics at Renaissance Macro Research.