‘If Not By Accident, By Design’: Why One Bank Sees US Recession

The Fed is on the brink of a policy error. You’ve probably heard that at least a half-dozen times in the past week.

Everyone’s shouting about it, including former Fed officials, former Treasury Secretaries and, notwithstanding a few sessions of re-steepening, the yield curve.

The irony — well, there are too many ironies to count right now, but one of the ironies — is that the Fed’s forthcoming policy mistake is a product of a policy mistake they already committed. Hindsight is 20/20, but QE should’ve ended last summer and hikes should’ve commenced in September.

“The Fed’s main policy error was to ignore the rise in inflation last year and getting blindsided,” Rabobank’s Philip Marey said, in a new note. The Fed’s reluctance to act preemptively “has set in motion a wage-price spiral that will be very difficult to reverse without hiking the economy into recession,” Marey sighed.

There are two threats to the US economy, one exogenous and one endogenous, Rabobank said. The exogenous shock is the war, which, contrary to some front-loaded forecasts I’ve read recently, Marey expects to impact the global economy in the back half of the year.

As usual, it’ll be low- and middle-income households that suffer the most. “As a major oil and gas producer, the US also gains from higher prices, but these gains will benefit these US producers rather than US consumers,” Marey wrote, adding that while “wealthy Americans” might benefit via their portfolios, low-income households “will be punished heavily by higher prices.”

That speaks to a simple point I’ve made repeatedly of late: Most people don’t invest in commodities, they consume them. Buying canned corn doesn’t make you a commodities trader — even if you later sell some to your neighbor at a profit once World War III starts. Surging commodity prices are extremely problematic for the average person. For the poor, and particularly for frontier economies, they’re a death knell. Figuratively and literally.

Marey delivered a pointed critique of the situation as it relates to the US economy. “America is better able to deal with an oil crisis than in the 1970s, but only on aggregate,” he wrote, adding that,

Instead of an international income transfer from the US to the Middle East, it is now a domestic income transfer from consumers to producers, and from the poor to the rich. Since this shock to the US economy is of a new variant, its effect is difficult to predict. If the impact is larger than anticipated by the Fed, the aggressive rate hikes might come at exactly the wrong time. What if low-income households get squeezed by both higher prices and higher interest rates? What if higher prices erode their budgets, deplete their savings and then these households can only borrow at rates that they cannot afford? Hiking into this uncertain environment at a high pace only increases the risk that the economy is pushed into recession.

Christopher Waller on Monday indicated the Fed is cognizant that such an outcome is possible. But policymakers feel they have no choice. Failing to lean (hard) against inflation now risks unanchored medium- and long-term expectations later. Officials view that as the worst possible outcome.

The latest installment of the New York Fed’s monthly consumer survey showed one year-ahead expectations soaring to a new record in March, even as the three-year outlook receded a bit (figure below).

Note that the middle-class (those in the $50,000 to $100,000 income bucket) harbored the highest inflation forecasts last month.

In any case, a recession in the name of preventing entrenched inflation (and unmoored expectations) is the lesser of two evils. Virtually everyone agrees on that point, as long as it’s presented as a binary choice between runaway inflation and a “regular” downturn. Other combinations of the same dynamics admit of more ambiguity.

The endogenous threat to the economy is a wage-price spiral, which Marey contends began last summer, when wage growth for job “switchers” started to accelerate. Some assumed a lack of bargaining power on labor’s part would prevent wages from picking up for job “stayers,” but that hasn’t proven to be the case. Wage growth for both is now very elevated (in excess of 7% for job switchers and more than 5% for stayers).

While a return to the glory days of unions seems far-fetched, labor is making headlines again as an economic actor with serious clout. Employers are desperate for workers, and willing to make all manner of concessions to acquire and keep them. Indeed, the biggest takeaway from the latest JOLTS data was the extent to which it supported the wage-price spiral narrative, something I endeavored to emphasize here.

Although openings fell slightly in the latest data, the gap with hires remained extraordinarily wide (figure above).

Rabobank cited persistent upward wage pressure for job stayers as evidence that inflation is on the brink of becoming entrenched. Short circuiting the loop may require restrictive policy.

Ultimately, Rabobank said the window for a so-called “soft landing” has likely closed. I’d have to agree. On March 14, I declared such a benign outcome all but impossible.

“Assuming the US recovery survives the slowdown in the second half of this year, the Fed is likely to push the economy into recession next year,” Marey said. “If it is not by accident, then it will have to be by design that the Fed’s monetary policy tightening causes a recession.”