Powell's bet against recession looks good - minus the credit crunch and a DC standoff
Stagflation advocate?Photographer: Al Drago/Bloomberg
Federal Reserve Chair Jerome Powell reckons the US economy can skirt recession. But the odds are stacked against him — thanks to banking, politics, and even the weather.
In Powell's view, the gravity-defying strength of American labor markets — on display again in jobs data published Friday, which showed a bumper increase last month — is smoothing the way for a soft landing, even after five percentage points of interest-rate hikes in little over a year.
"It's possible that this time is really different," the Fed chief told reporters last week after raising rates for a tenth straight time.
Still, a labor 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. And for 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 standoff 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 Niño. The weather system is gathering force, threatening extreme conditions around the world that would disrupt commodity supplies, push prices higher, and keep the Fed focused on inflation.
And if this trifecta does tip the economy into a slump, there may not be much that Powell and his colleagues can do about it. Rate cuts are the main recession-fighting tool — but it's tricky for the Fed to deploy them when it's 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% since March last year. In recent history, the number of cases when that kind of policy didn't 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," says James Galbraith, an economics professor at the University of Texas who in 1978 worked on the legislation that enshrined the Fed's full-employment goal.
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's 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 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.
Crunch Coming?
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's more, stresses in the banking system have a tendency to snowball. Early assurances that SVB was an extreme outlier now look wide of the mark, as contagion has spread. Taken together, bank failures in 2023 already rival those in 2008 in terms of asset size.
At his press conference, Powell called the resolution of First Republic — taken over by JPMorgan Chase & Co. last week — an "important step toward drawing a line" under the crisis. Volatility in shares of other regional lenders since then suggests the line remains dotted.
Debt Ceiling Debacle?
In Washington, meanwhile, the debt-ceiling standoff is escalating toward something that looks more dangerous than past episodes.
Treasury Secretary Janet Yellen sent a blunt warning to US lawmakers on 1 May: her department's ability to use special accounting maneuvers to stay within the debt limit could be exhausted as early as the start of June. The Treasury has been ducking and weaving to avoid default since hitting the current statutory limit of $31.4 trillion in January.
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. McCarthy has already pushed through a Republican bill that would impose sweeping spending cuts in return for raising the ceiling, something Democrats have rejected.
In a best-case scenario, there'll be a period of elevated market stress ahead of a deal. In the worst, default would 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," Powell told reporters last week. Translation: If recession hits, don't expect us to ride to the rescue with monetary stimulus.
At 5% in March, the headline consumer-price inflation rate has fallen steeply from a peak above 9% 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 around 4% the end of this year. And it could be worse.
Enter El Niño
The National Oceanic and Atmospheric Administration projects a 62% chance of the extreme weather system developing between May and July, rising to 80% by the fall. A strong El Niño, 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 Niño's 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 nonexistent.
Of course, a soft landing is possible — and some of the signs are favorable. In July 2022, Fed Governor Christopher Waller argued that a shift in the labor market — with vacancies declining but unemployment holding steady — could deliver a disinflation that's relatively pain-free. Since then, vacancies have indeed declined while jobless rates remain low.
Olivier Blanchard, an economist at the Peterson Institute, took the opposite side in that debate — and says he still thinks higher unemployment is on the cards. But, Blanchard concedes that "if we continue to have a decrease in vacancies and no increase in unemployment for another couple of months, then Waller could turn out to be right."
'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's some evidence that's what is happening, as manufacturing and real estate bottom out ahead of any significant downturn in labor markets.
"My best guess is that economic growth will be sluggish in coming months," says Karen Dynan, a professor at Harvard. "We are in for a slog." That might not feel great, but it would mean an outright recession is avoided.
Still, it's 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's a lesson from the last few years, it's that not much is certain. But the basic point, that a recession is more likely than not, still stands.
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's a lesson from the last few years, it's that not much is certain. But the basic point, that a recession is more likely than not, still stands.
That's bad news for Powell's optimistic forecast. Worse, a shallow recession might not even be enough to do the job of bringing inflation back to target. On average, past downturns have only lowered core inflation by a limited amount, and with significant lags.
Put the pieces together, and stagflation — with the economy contracting and inflation still too high — is the likeliest outcome.
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