News analysis

Odds stacked against US economy avoiding recession

A US labour market that remains too hot to handle means the Fed will have to hold rates higher for longer to quell inflation – the very reason recession risks are so high. PHOTO: AFP

WASHINGTON - Federal Reserve chair Jerome Powell reckons the United States economy can skirt recession. But the odds are stacked against him – thanks to banking, politics and even the weather.

In Mr Powell’s view, the gravity-defying strength of American labour markets – on display again in jobs data published last Friday, which showed a bumper increase last month – is smoothing the way for a soft landing, even after 5 percentage points of interest rate hikes in little over a year.

“It is possible that this time is really different,” the Fed chief told reporters last week after raising rates for a 10th straight time.

Still, a labour market that remains too hot to handle means the Fed will have to hold rates higher for longer to quell inflation – the very reason recession risks are so high. Also, for Mr Powell’s forecast to come true, the US economy will have to overcome three major obstacles, all pointing to a downturn in the second half of this year.

  • A looming credit crunch: Driven by the combined impact of Fed tightening and bank failures, it will likely hit small businesses and commercial real estate especially hard.
  • A debt ceiling deadlock in Washington: Coming to a head right now, the partisan stand-off threatens a period of intense financial stress. If the US government does default, the blow to the economy and markets could rival the 2008 crash.
  • A climate wildcard from El Nino: The weather system is gathering force, threatening extreme conditions around the world that will disrupt commodity supplies, push prices higher and keep the Fed focused on inflation.

If this trifecta does tip the economy into a slump, there may not be much that Mr Powell and his colleagues can do about it. Rate cuts are the main recession-fighting tool – but it is tricky for the Fed to deploy them when it is still struggling to bring inflation back to target.

The fastest monetary tightening in four decades was always going to come at a price. The Fed has jacked up rates from near-zero to above 5 per cent since March last year. In recent history, the number of cases when that kind of policy did not lead to recession is precisely zero.

“I don’t believe there is a good example of a ‘soft landing’ in the five or so decades that the Federal Reserve has been mostly in charge of macroeconomic policy and don’t see why the present situation should be different,” said Dr James Galbraith, an economics professor at the University of Texas.

No accident

The dynamics that lead from higher rates to a shrinking economy are straightforward. As borrowing costs climb and asset prices fall, spending slows and businesses cut jobs. For central banks, that rise in unemployment – and the resulting drag on wages – is the mechanism that brings inflation back to target.

Recessions, in other words, are not an accidental side effect of attempts to rein in inflation. They are the main show. That is why, even when the Fed was just getting started with rate hikes last year, Bloomberg Economics forecast a downturn in the second half of 2023.

Then came the banking scare. The wave of failures that began with Silicon Valley Bank (SVB) was, in some sense, not a surprise. No one knew exactly what would break as the Fed hiked – but everyone suspected that something would.

If Fed officials could choose, though, they would probably not have picked collapsing regional banks as their preferred mechanism for delivering disinflation.

Bank failures amplify the effect of higher interest rates in curbing credit. Even last year, the Senior Loan Officer Survey – the Fed’s preferred barometer – showed lending standards getting tighter, and that trend will only accelerate after SVB. Typically, lending slowdowns follow with a lag after banks turn cautious, one reason to pinpoint the downturn in the second half.

What is more, stresses in the banking system have a tendency to snowball. Early assurances that SVB was an extreme outlier now look wide off the mark as contagion has spread. Taken together, bank failures in 2023 already rival those in 2008 in terms of asset size.

Debt ceiling debacle?

In Washington, meanwhile, the debt ceiling stand-off is escalating towards something that looks more dangerous than past episodes.

Treasury Secretary Janet Yellen sent a blunt warning to US lawmakers on May 1: Her department’s ability to use special accounting manoeuvres to stay within the debt limit could be exhausted as early as the start of June.

President Joe Biden and House Speaker Kevin McCarthy are due to hold debt ceiling talks on May 9 but expectations for a breakthrough are muted. Mr McCarthy has already pushed through a Republican Bill that will impose sweeping spending cuts in return for raising the ceiling, something the Democrats have rejected.

In a best-case scenario, there will be a period of elevated market stress ahead of a deal. In the worst, default will tip the global financial system into the abyss and the US economy into a deep downturn.

If growth does start to slide, sticky inflation will limit the Fed’s room to respond.

With prices rising much faster than the Fed wants, “it would not be appropriate to cut rates and we won’t cut rates”, Mr Powell told reporters last week. Translation: If recession hits, do not expect us to ride to the rescue with monetary stimulus.

At 5 per cent in March, the headline consumer price inflation rate has fallen steeply from a peak above 9 per cent last summer. But that was the easy part – with unsnarling supply chains and falling energy costs doing the Fed’s job for them. The hardest yards lie ahead.

Bloomberg Economics forecasts that rising wages, and the end of the disinflationary impulse from goods and energy, will leave core inflation stuck at around 4 per cent at the end of this year – and it could be worse.

Enter El Nino

The National Oceanic and Atmospheric Administration projects a 62 per cent chance of the extreme weather system developing between May and July, rising to 80 per cent by the fall. A strong El Nino, as some models predict, could add to inflation.

In that scenario, storms and floods hit California and the South, hurting food and energy output. Globally, droughts in parts of Asia and heavy rain in South America and Africa hit harvests.

The International Monetary Fund says strong El Ninos can add 4 percentage points to commodity price inflation. Add that to the mix and the space for Fed rate cuts shrinks from small to non-existent.

Of course, a soft landing is possible and some of the signs are favourable. In July 2022, Fed governor Christopher Waller argued that a shift in the labour market – with vacancies declining but unemployment holding steady – could deliver a disinflation that is relatively pain-free. Since then, vacancies have indeed declined, while jobless rates remain low.

‘In for a slog’

Other outcomes are possible. One is a “rolling recession” – where one industry after another takes a hit, but the economy as a whole never shrinks. There is some evidence that is what is happening as manufacturing and real estate bottom out ahead of any significant downturn in labour markets.

“My best guess is that economic growth will be sluggish in the coming months,” said Dr Karen Dynan, a professor at Harvard. “We are in for a slog.”

This might not feel great but it would mean an outright recession is avoided.

Still, it is tough to make either soft landing or rolling recession the base case. The latest reading from Bloomberg Economics’ recession probability model suggests that a downturn starting by July is a near certainty. Take that with a grain of salt – if there is a lesson from the last few years, it is that not much is certain. But the basic point, that a recession is more likely than not, still stands. BLOOMBERG

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