We’ve done it. We’ve jettisoned the two-quarter recession definition. And it didn’t take very long, either.
Two business days on from the advance read on second quarter GDP (which, if the two-quarter rule applied, showed the US economy fell into a recession in the April to June period) and virtually no one, not even ardent bears, is unequivocally in the recession camp.
From the very day the advance read on Q1 GDP in the US showed a contraction, I argued policymakers and White House officials would likely be compelled to redefine the generally accepted definition of the term “recession.” That wasn’t a “prediction,” as such. I’m not making any claim to prescience here.
My point, as reiterated at regular intervals, was simple: With the fiscal impulse waning, the Fed hiking aggressively, mortgage rates rising rapidly and inflation stuck stubbornly at 40-year highs to the detriment of consumer sentiment and business confidence, the odds of a small contraction in the second quarter were elevated.
Given the (mostly plausible) arguments for waving away Q1’s contraction by reference to “the way we calculate GDP,” my contention was that officials risked an awkward scenario wherein a quirky negative print for the first quarter was followed by a shallow Q2 contraction, meeting the commonly accepted (if unofficial) definition of a recession, despite a hodgepodge of good reasons to believe the economy isn’t actually in a proper downturn.
That, I suggested, would compel the Biden administration and Fed officials to embark on a PR blitz aimed at demolishing the two-quarter rule. That’s precisely what’s happened. Neel Kashkari joined the effort on Sunday when, during a largely pointless cable television cameo, he told CBS’s John Dickerson that (edited for clarity),
Typically, recessions demonstrate high unemployment and we’re not seeing anything like that. The labor market so far, is very strong. We are seeing some sectors like the tech sector start to shed workers or start to cool hiring. But fundamentally, the labor market appears to be very strong, while GDP — the amount the economy is producing — appears to be shrinking. So, we’re getting mixed signals out of the economy. From my perspective, in terms of getting inflation in check, whether we are technically in a recession or not, doesn’t change my analysis. I’m focused on the inflation data.
Recapping on Monday, BMO’s Ian Lyngen and Ben Jeffery called Kashkari’s remarks “consistent with the FOMC’s hawkish stance.” His comments suggest that “despite the two consecutive quarters of negative GDP (formerly known as a recession), monetary policymakers are on track to bring Fed funds to the 3.25-3.50% range or beyond.” Note the quip: “Formerly known as a recession.”
As discussed at some length in “Help (Still) Wanted,” the Fed needs to dispel the notion that the economy is already in a recession. Because if it is, that suggests additional rate hikes are a policy mistake, unless the goal is to induce a recession in the service of fighting inflation. That may very well be the goal, but until someone at the Fed is willing to admit as much publicly, the rhetoric will continue to revolve around talking points which reference labor market strength in dispensing with the recession story.
For their part, market participants are happy to accept the notion that the economy isn’t severely impaired, but at the same time, both equities and bonds have embraced the slowdown narrative as a rally catalyst. “This dovish pivot speculation has only been bolstered by the clear deceleration of economic data,” JonesTrading’s Mike O’Rourke said. “The advance Q2 GDP report… only reinforced hopes for an earlier pivot as the term ‘recession’ gets redefined.”
This is a very awkward waltz. The Fed doesn’t want the recession narrative, but it may want a recession. The recession narrative, if it runs away from them, could become self-fulfilling through several channels, including a further deterioration in business confidence (to the detriment of investment, which basically flatlined in the second quarter) or, worse, wider credit spreads. It also undermines whatever’s left of the soft landing fable. The market doesn’t want a recession, but risk assets do want the recession narrative, because traders believe the fear of a recession will compel the Fed to pivot earlier. But front-running that expected pivot makes it less likely because rising stock prices ease financial conditions, at the risk of stoking inflation and thereby pushing a Fed pivot further out.
This is why it’s imperative the Fed doesn’t inadvertently lapse back into forward guidance. They can’t “listen” to the market. They revoked the market’s license to co-author the policy script earlier this year. Now, with inflation showing no signs of abating (outside of PMI price indexes anyway) and rates plainly keen to foist the recession narrative on policymakers (via less aggressive terminal rate pricing and expectations for the commencement of rate cuts in 2023, for example), the Fed needs to ignore the market, even if that risks coming across as capricious.
With apologies to Esther George (who, in her June dissent, emphasized the virtues of retaining at least a semblance of predictability on the road to higher rates), there’s a sense in which Fed policy needs to be a black box when inflation threatens to undermine the institution’s credibility.
In a testament to just how determined the market is to hear what it wants to hear, even the withdrawal of forward guidance was (perversely) interpreted as a dovish development. That’s an incorrect read. A bad bet. As JonesTrading’s O’Rourke correctly pointed out, “forward guidance is the tool of a dovish central bank.” The withdrawal of forward guidance is tantamount to the withdrawal of transparency — dovish outcomes are still possible, but they aren’t guaranteed. If they were, central banks would tell you as much.
More than low rates and asset purchases, it was forward guidance which underpinned the short vol trade in all its various manifestations. The demise of forward guidance is designed to inject volatility or, at the least, it’s tantamount to removing a powerful vol suppressant. While acknowledging that market outcomes are never “wrong” or “right” (they just are what they are, so to speak), a risk-on reaction to the explicit removal of forward guidance is the wrong trade.
“We would equate forward guidance to retailers’ release of monthly same store sales,” O’Rourke went on to say. “When times are great, they want to tell you every month, but when they slow, they drop the practice.”