Deutsche Bank Stunner: ‘We Will Get A Major Recession’

Starting last year, Deutsche Bank began publishing a new series of papers dedicated to furthering what Chief Economist David Folkerts-Landau described as “intellectual diversity.” They called the new series “What’s in the tails?”

The express goal was to “stimulate debate” by presenting “reasonable alternatives” to the bank’s house views and central forecasts.

The inaugural edition found Folkerts-Landau joined by Peter Hooper and Jim Reid, who together explored a scenario in which post-pandemic policy shifts resulted in unmoored inflation outcomes.

Among other things, they cautioned that as noble as the pursuit of equality and social justice are, monetary authorities shouldn’t lose track of their obligation to guard against price spirals. “Despite the shift in priorities, central bankers must still prioritize inflation,” they wrote, in June of 2021.

Read more: Deutsche Bank Warns Of ‘Devastating’ Inflation ‘Time Bomb’

To state the obvious, the tail risk described in the inaugural edition of “What’s in the tails?” ended up becoming the new macro reality.

On Tuesday, Folkerts-Landau published a new installment of the same series. The title: “Why the coming recession will be worse than expected.”

Deutsche, you’ll note, recently adopted a US recession in late-2023 / early-2024 as the house view. That was a first on Wall Street. Folkerts-Landau expressed incredulity at the reluctance of other banks to follow suit.

“I am very surprised we are the extreme outlier on the Street,” he wrote, adding that when you consider “the macro starting point, my view is that the burden of proof should be on why this boom/bust cycle won’t end in a recession.”

It’s probably just a matter of time before more banks jump on what’s almost destined to be a crowded recession bandwagon, but Deutsche suggested Tuesday that even if a recession becomes consensus, Wall Street may fail to recognize the potential for a “significant” downturn.

There are two primary reasons consensus is behind the curve in recognizing elevated inflation odds, Folkerts-Landau said. The first is tied to the old adage about “fighting the last war.” Deutsche contrasted the recovery from the financial crisis with the current recovery, noting that,

[T]he pandemic recession was not caused by excessive leverage but by enforced shutdowns alongside consumers’ personal fears of the virus which inhibited activity. So there was scope for a much quicker recovery once those impediments passed — especially when aggregate demand was supercharged by massive fiscal support packages.

Second, Deutsche suggested the tendency for inflation forecasts to mean revert may be lulling market participants to sleep. The underappreciated risk, the bank warned, is that longer-term inflation expectations become unmoored.

Speaking to that, Deutsche argued that inflation could remain elevated “for longer than generally anticipated” due to i) a reversal of structural disinflationary forces (including globalization, demographic shifts and climate change), ii) cost-push dynamics, iii) labor market tightness, iv) the distinct possibility that the Fed will move too slowly to take policy into restrictive territory, v) the interplay between expectations and realized inflation (i.e., what consumers are actually paying at the grocery store and at the gas pump), and vi) a “dramatic” shift in inflation psychology, characterized by resilient profits as consumers absorb price increases.

The figure (below) is a house indicator which quantifies “how far the economy has strayed from the Fed’s mandates of price stability and maximum sustainable employment,” as the bank explained. It’s not complicated. It’s just the inflation overshoot (versus target) plus the unemployment undershoot.

Deutsche calls that the “Fed misery index,” a play on the more familiar gauge.

The read-through is straightforward: The Fed is well behind the curve and instances of positive readings on the index are generally followed by recessions.

Jerome Powell and his colleagues “have a lot of work to do to catch up,” Folkerts-Landau said, on the way to suggesting neutral might be as high as 5%. Modestly restrictive territory (in the interest of winning the inflation battle) might then require a fed funds rate as high as 6%.

“This monetary tightening and the financial upheaval that accompanies it will push the economy into a significant recession by late next year,” Deutsche cautioned, adding that unemployment may rise “several percentage points” consistent with a fairly deep recession which is “needed to do the job.”

I’d be remiss not to include two extended excerpts from the summary section on the first page of what, ultimately, is a 13-page missive. To wit, abridged, from the note:

We are currently experiencing a paradigm shift in macroeconomics. Consensus forecasts, of which there is traditionally little deviation around, have been consistently wrong over the past decade or so and especially in the last couple of years. Forecasters underestimated the scale of the pandemic rebound, the inflationary impact of the stimulus packages and the fact that it wasn’t transitory. Do we have a huge problem in the profession with models that are not fit for purpose? These same forecasters and models now expect us to believe there will be a soft landing from a starting point at which a soft landing has never been achieved.

In short, the scourge of inflation has returned and is here to stay. While we may have seen the highs now, it will be a long time before it recedes back to acceptable levels near the Fed’s 2% target. As a society, monetary tightening is a policy that affects all of us; and it is sorely tempting to take a go slow approach hoping that the US economy can be landed softly onto a sustainable path. This will not happen. Our view is that the only way to minimize the economic, financial, and societal damage of prolonged inflation is to err on the side of doing too much. The labor market and household balance sheets are strong, and the only way to push down aggregate demand is to raise rates higher and faster than might seem reasonable. Thinking back to the early Volcker years we ask ourselves whether the massive increase in rates would be viewed today as being over the top under similar circumstances. Probably, but they were proved necessary. Like then we will get a major recession, but our strongly held view is that the sooner and the more aggressively the Fed acts, the less longer-term damage to the economy there will be. Markets just need to be shown that the Fed will do what is necessary and not tolerate prolonged inflation, even if it is “only” in single digits. The US is extremely fortunate in having an apolitical central bank that does what is right for the country even if that means an unavoidable recession.

Those passages, from Folkerts-Landau’s intro, are provocative. And, as explained here at the outset, that’s on purpose. In the same introductory section, he reiterated that “we set up this series last June, encouraging our analysts to give an alternative to the official house view where we felt there was a well-reasoned and credible alternative scenario.”

Looking out a bit further, Deutsche said the downturn could begin in earnest late in 2023, and the Fed would be in a position to reverse course midway through 2024, when the economy should pick back up and inflation recede. “In our view, the sooner this process takes place the better,” the bank remarked.