Business cycle chart book


Q2 GDP could be slightly negative, but the NBER probably won’t define Q1 or Q2 2022 as part of a recession. Why? Gross Domestic Income (GDI) was positive in Q1, jobs were added every month throughout Q1 and Q2, and that likely wouldn’t meet their significant depth consideration. Under a heading titled Why doesn’t the committee accept the two-quarter definition?, they note: “[when defining a recession] we consider the depth of the decline in economic activity. The NBER’s definition includes the phrase “a significant decline in economic activity.” Thus, real GDP could decline by relatively small amounts in two consecutive quarters without justifying the determination that a peak has occurred.

Looking ahead, the risk of recession is still high. In any given expansion month, the historical probability of entering a recession in the next twelve months is about 20%, and I would say the odds are at least twice as high right now. The biggest risk is that the Fed tightens excessively. As the saying goes: expansions don’t die of old age, they are killed by the Fed. (A large enough exogenous shock obviously will too.) The Fed could very well panic over another policy mistake, overdoing it one way and then the other.

However, any recession that may occur over the next year is, in my view, likely to be of similar depth and duration to the recession of the early 1990s (i.e. shallow and short). And a soft landing that is ultimately characterized as a mid-cycle slowdown rather than a recession is still possible. I think the Fed pivot will happen sooner than expected. According to the price of Eurodollar futures (3-month LIBOR rate expectations), the peak of the Fed’s hike cycle shifted from June 2023 (two months ago) to March 2023 (one month ago). month) and December 2022 (currently). The Fed has not (yet) inverted the 3-month and 10-year yield curve, which has always inverted before past recessions. Historically, the 3m10yr reversal has been a necessary but not sufficient signal for a recession. In other words, 3m10yr reversals can be false positives.

Fed elector Esther George described the framework of a dovish shift last week:

“Moving interest rates too quickly raises the prospect of oversteer…the adjustment has been significant. This is already a historically rapid pace of rate increases at which households and businesses need to adapt, and more abrupt changes in interest rates could create tensions, either in the economy or the financial markets, this would compromise the Fed’s ability to deliver on its promises…some forecasts call for interest rate cuts interest as early as next year.These projections suggest to me that a rapid pace of rate hikes carries the risk of policy tightening faster than the economy and markets can adjust.

She went on to suggest that the Fed should be cautious about inverting the yield curve (eg on the 3m10y). Pretty conciliatory comments from someone once considered a “megahawk”. In her dissenting vote last month, she also rightly reminded us (and her colleagues at the Fed) that monetary policy acts with a lag. Maybe the Fed will start looking through the windshield instead of the rear view mirror. They were behind the curve when tightening and could also be behind the curve when relaxing.

Other FOMC members may be looking at a pause (or at least a slowdown) in the bullish cycle in the coming months as the 1-year real rate looks likely to move into positive territory. As the Fed’s Barkin said in June, “What I’m trying to achieve is positive forward-looking real rates across the curve. We’re there 5+ years, but we’re not We’re not short-term on the curve…which could give you a signal of when to start slowing down.” Since these comments, the real 2-year and 3-year rates have moved into positive territory. Real 1-year yields are likely to be positive soon too.

When it comes to inflation expectations, what difference a revision and a month can make. The University of Michigan’s forward inflation expectations fell from 3.1% in a preliminary reading in May (a sharp rise from previous readings) to 2.5% in June (a sharp drop from compared to previous readings). This May preliminary report pushed the Fed into a surprise rate hike of 75 basis points. As we know, Powell is very concerned that inflation expectations are no longer anchored. For now, they seem anchored. The New York Fed’s inflation survey and market-based inflation expectations also support this conclusion. Anchored inflation expectations should allow for a more cautious and less panicked approach.

The Core PCE YoY, historically the Fed’s preferred inflation measure, has fallen for three consecutive months now; perhaps to be part of the “clear and convincing evidence” that Powell could refer to in the coming months.

Consumer confidence, one of the main economic indicators that has been on a worrying downtrend, improved slightly last week. This corresponds to the decline in national average gasoline prices (there is an inverse relationship between gasoline prices and consumer confidence). Overall, a continued decline in gasoline prices will likely continue to lower inflation expectations and simultaneously improve consumer confidence, which improves the outlook.

Finally, with all the talk of the US/global recession, it’s worth pointing out that the world’s 12 largest economies, all 12, have manufacturing PMIs above 50 (expansionary readings) in June 2022. And China, the the world’s second-largest economy, has a manufacturing PMI that has risen.


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