“Encouragingly, economic activity has decelerated,” Goldman’s David Mericle and Ronnie Walker wrote, while reassessing the outlook for the US economy in the context of the Fed’s increasingly aggressive efforts to douse the hottest inflation in 40 years.
The quote is emblematic of a paradox that became embedded in market psychology over a decade of extreme monetary accommodation. Good news can be bad news and vice versa. Everything is contextualized via central banks’ reaction function, and signs of economic vitality argue for tighter policy.
Markets have grappled with that dynamic for years, but it’s extreme in 2022. An overheated economy paired with an unthinkable disconnect between job openings and people willing to fill them, is amplifying the inflationary impulse from lingering supply chain disruptions and a severe commodities shock. The Fed, lacking the capacity to address supply-side factors, needs to cool demand.
So, signs of economic deceleration and a downshift in labor demand are thus “encouraging” — an economy that grows at a rate below potential can help inflation moderate. That, in turn, can reduce the need for draconian policy tightening, which is the surest path to recession. The (wholly counterintuitive) implication is that the best way to avoid a downturn is for the economy to slow.
Goldman noted a “sharp” deceleration in their current activity indicator, and slower (albeit still very robust) payrolls growth. Average hourly earning are also cooling. “Unfortunately, there has been some discouraging inflation news too,” the bank sighed, flagging additional upward pressure on commodity prices and consumer inflation expectations. “Our monthly version of the Fed’s index of Common Inflation Expectations has risen to a level that is hard to ignore,” the bank remarked, adding that the increase in shelter inflation observed in May’s CPI report wasn’t the best news.
The Fed, concerned about their credibility and the possibility that long-term inflation expectations may become a semblance on unanchored, has responded. “The Fed has front-loaded rate hikes more aggressively, terminal rate expectations have risen, and financial conditions have tightened further and now imply a substantially larger drag on growth — somewhat more than we think is necessary,” Mericle and Walker remarked.
The figure on the left (below) underscores how rapidly financial conditions have tightened this year.
The figure on the right (above) illustrates how much additional growth “drag” was generated from June 10 to June 17 (i.e., the red boxes show where the dark blue bars were prior to May’s CPI report).
On Goldman’s estimates, the drag on GDP from the FCI impulse is a half percentage point larger now for Q3 2022 through the end of next year than it was prior to the latest CPI data in the US. That drag is “now as severe as -2pp on annualized growth” for the back half of this year, Mericle and Walker went on to say, adding that “when combined with the fiscal drag and decline in real disposable income this year, this increased drag from tighter financial conditions is now somewhat more than we think is necessary to put the economy on a moderately below-potential growth trajectory that would give the Fed the best chance of success.”
That’s a (very) euphemistic way of saying that the odds of a soft landing are now lower thanks to the FCI tightening witnessed over the past two weeks. Goldman lowered their growth forecasts accordingly to 2.8%/1.75%/0.75% for the remaining three quarters of 2022, and 1.0%/1.5%/1.5%/1.75% for 2023 Q1-Q4. Growth this year will be around 2.4% on an annual average basis and just 0.9% on a Q4/Q4 basis. For 2023, those figures are both 1.4%.
Intuitively, a lower growth path and a Fed that seems inclined to pushing the envelope raises the odds of a recession. As Goldman put it, “a front-loaded hiking cycle front-loads recession risk.” The bank now sees a 30% probability of a downturn over the next year, up from 15% previously, and a one in four chance of a recession in the subsequent 12 months assuming a downturn is avoided during the first year. The implication: The cumulative probability at the two-horizon is now 48%.
As far as calibrating monetary policy such that financial conditions tighten just enough to slow the economy and cool inflation but not so much that, in conjunction with fiscal drag, the combined effect induces a recession, Mericle and Walker conceded it’s “hard to be precise with these estimates.”