Earlier this month we sent out an edition of Financially Speaking to illustrate our feelings about recession. At the time our feelings were that we would not see a recession in 2022, but that we might see one later in 2023 or 2024. Those sentiments generated responses from our readers asking why we felt a recession might be possible in 2023 or 2024 without one occurring in 2022. We feel this is a perfectly fair question and we want to illustrate our thoughts on the matter. In this edition of Financially Speaking, we will take a look at the current situation, which has evolved since our last writing, and why we continue to believe that recession won’t happen in 2022 but could happen in 2023 or 2024. As a refresher, remember recession is defined as two consecutive quarters in a row with negative (shrinking) Gross Domestic Product (GDP). As always, the team at Barron Financial Group are only a phone call or email away if you have further questions or prefer a personal discussion.
What’s Changed?
As stated above, we believe the current recession situation has evolved since our last writing. On Friday, June 10 the Consumer Price Inflation (CPI) report for May was released showing that annual CPI was at 8.6%. This was higher than the April reading of 8.3% and came as a surprise to both economists and the folks at the Federal Reserve (FED). No one expected inflation to drop substantially, but most felt a reading of 8.3% or slightly lower was most likely. The 8.6% reading came as a shock and markets responding with the S&P 500 dropping for three days in a row to the then YTD low of 3735. A few days later the Fed met for its June meeting and decided to raise interest rates by 75 basis points (bps) or 0.75%. This after FED Chair Powell had stated at the May meeting that 75 bps increases were off the table. We believe the change in FED sentiment here is significant. We believe it indicates that the FED now realizes it is behind the curve on inflation and needs to take a much more aggressive approach to address it. The base FED Funds interest rate, after the 75 bps increase, now stands at 1.00-1.25%. This up from 0.00-0.25% during the pandemic.
The Neutral Rate
Before we go too far into why this matters for recession, it makes sense to identify and define an important term with respect to interest rates, the Neutral Rate. The Neutral Rate is the interest rate that will not positively, or negatively, affect the economy, or more specifically, GDP. Unfortunately, there is no direct calculation or reference point for the neutral rate, it is something that needs to be found by trial and error. Everyone knows that the pandemic interest rate level of 0.00-0.25% was well below the neutral rate as intended to drive the economy to recover from the pandemic. Most experts believe that today’s 1.00-1.25% is still well below the neutral rate. But what about the interest rate level coming after more FED meetings and rate increases? We have FED meetings scheduled for July, September, November and December. Most experts believe another 75 bps increase is likely for July, possibly another in September, followed by either 25 or 50 bps in November and December to close out the year. FED Funds Futures predict the base interest rate at year-end to be 3.50-3.75%, a significant increase from today’s level. The questions right now are 1) will the FED move that aggressively? And 2) is that interest rate above or below the neutral rate. There is no way for the FED, or anyone else, to know exactly what the Neutral Rate is. This is important because if that rate is above the Neutral Rate, then the likelihood of recession increases. Rates above the Neutral Rate are expected to negatively affect GDP, hence potential recession.
Conclusion
This leaves us with an interesting mix of economic factors. Looking back at our previous edition we identified the three recession concerns of inflation, the supply chain and labor markets. We now feel that inflation is a bigger problem and one that appears to be leading to interest rates increasing above the Neutral Rate. However, we still also believe that the supply chain and labor markets are improving and will continue to do so. If the supply chain and labor markets improve enough, that could allow the FED to ease its rate increases and not go above the Neutral Rate. However, if the FED continues on the current path, and the supply chain and labor markets don’t greatly improve, we have what we see as a real path toward recession with interest rates rising above the Neutral Rate. For timing we expect Q2-2022 GDP will be slightly positive, though GDP predictions have been dropping. Q1-2022 GDP was negative, so if Q2 GDP comes in negative we have met our recession definition. But, if we’re right and Q2-2022 comes in positive that will mean we will not get the second consecutive quarter of negative GDP in Q2. Then, even if Q3 and Q4 have negative GDP we won’t get the Q4 estimate until January 2023. Thus, our base case is that recession won’t happen until we are at least one or two quarters into 2023, meaning 2022 remains “safe”. All of these factors are hard to predict so the timing could easily shift a quarter or two in either direction. From a severity view we don’t expect the possible coming recession will be a deep one. We believe that the recession will be what we refer to as “Event Driven” due to the affects from the pandemic on monetary and fiscal policy, along with the follow-on effects on the supply chain and labor markets. If we do have a recession we do not expect it to last more than the two quarters needed to establish it in the first place. Worth noting is one of the great quotes I’ve read, where an analyst suggested that economists have predicted 9 of the last 5 recessions. Indicating that economists have a habit of crying wolf regarding recession and it doesn’t always happen. The take away is to remember that we are doing our best to understand the current underlying conditions, but with all the moving parts it would be easy to miss the ultimate outcome. We will try to keep you informed along the way.
All the best,
Jim