Business cycle chart book

Q2 GDP might 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 have been added every month throughout Q1 and Q2, and it likely wouldn't meet their significant depth consideration. Under a heading titled Why doesn’t the committee accept the two-quarters definition?, they note: "[when defining a recession] we consider the depth of the decline in economic activity. The NBER definition includes the phrase, “a significant decline in economic activity." Thus, real GDP could decline by relatively small amounts in two consecutive quarters without warranting the determination that a peak had occurred.”

Looking ahead, the risk of recession is still elevated. In any given month of expansion, the historical probability of entering a recession over the subsequent twelve months is about 20%, and I’d say chances are at least twice that high right now. The biggest risk is that the Fed overtightens. As the adage goes: expansions don't die of old age—they’re killed by the Fed. (A big enough exogenous shock will do it too obviously.) The Fed very well may panic into another policy mistake, overdoing it one way and then the other.

However, any recession that does potentially come in the next year or so 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’s eventually characterized as a mid-cycle slowdown rather than a recession is still possible. I think the Fed pivot will happen sooner than many expect. As priced by Eurodollar futures (expectations for 3-month LIBOR rates), the Fed hiking cycle peak has moved from June 2023 (two months ago), to March 2023 (a month ago), to December 2022 (currently). The Fed has not (yet) inverted the 3m10yr yield curve, which has always inverted prior to past recessions. Historically, 3m10yr inversion has been a necessary but not sufficient signal for a recession. In other words, 3m10yr inversions can be false positives.

Fed voter, Esther George, outlined the framework for a dovish shift last week:

"Moving interest rates too fast raises the prospect of oversteering... the adjustment has been significant. This is already a historically swift pace of rate increases for households and businesses to adapt to, and more abrupt changes in interest rates could create strains, either in the economy or financial markets, that would undermine the Fed’s ability to deliver... some forecasts are predicting interest rate cuts as soon as next year. Such projections suggest to me that a rapid pace of rate increases brings about the risk of tightening policy more quickly than the economy and markets can adjust.”

She went on to imply that the Fed should be cautious about inverting the yield curve (e.g., on the 3m10y). Pretty dovish comments from someone once considered a “megahawk.” In her dissenting vote last month, she also rightly reminded us (and her Fed colleagues) that monetary policy acts with a lag. Maybe the Fed will start looking through the windshield rather than the rearview mirror. They were behind the curve on tightening and may be behind the curve on easing as well.

Other FOMC members might consider a hiking cycle pause (or at least slowdown) in the coming months given that the 1-year real rate looks likely to move into positive territory. As the Fed’s Barkin put it in June: "what I’m trying to get to is positive forward-looking real rates across the curve. We’re there at 5 years and up, but we’re not there on the short end of the curve... that might give you a signal on when to start to slow." Since those comments, 2-year and 3-year real rates have moved into positive territory. 1-year real rates will likely be positive soon too.

Turning to inflation expectations, what a difference a revision and a month can make. The University of Michigan's forward inflation expectations went from 3.1% on a preliminary May reading (a sharp move higher from prior readings) to 2.5% in June (a sharp move lower from prior readings). That preliminary May report spooked the Fed into a surprise 75bp rate hike. As we know, Powell is very concerned about inflation expectations becoming unanchored. As of right now, they appear to be anchored. The New York Fed inflation survey and market-based inflation expectations also support that conclusion. Anchored inflation expectations should allow for a more prudent, less panicky approach.

Core PCE YoY, historically the Fed’s favored inflation measure, has declined for three consecutive months now; perhaps to be part of the "clear and convincing evidence" Powell may refer back to in coming months.

Consumer sentiment, one of the leading economic indicators that has been in a concerning downtrend, improved slightly last week. That’s consistent with the decline in national average gas prices (there’s an inverse relationship between gas prices and consumer sentiment). Generally speaking, a continued decline in gasoline prices will likely continue to bring down inflation expectations and simultaneously improve consumer sentiment—both improve the outlook.

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