William De Vijlder

The Federal Reserve’s Senior Loan Officer Opinion Survey sheds light on how changes in monetary policy influence banks’ credit standards and expected loan demand. Based on the historical relationships, the latest survey points towards a high likelihood of average negative growth of the volume of company and household investments over the next several quarters. Moreover, recent research shows that since 2009, the maximum impact of monetary policy on inflation may be reached more quickly. Based on the relationship between credit standards, expected credit demand and investments by companies and households, as well as on the possibility that transmission lags have shortened, decisions by the Federal Reserve will more than ever be data-dependent.

The preliminary inflation numbers for February had the effect of a cold shower due to the acceleration of core inflation. To assess the observed price developments since the start of last year, monthly inflation has been calculated for the more than 400 HICP components.  The frequency distribution for average monthly inflation between October 2022 and January 2023 has hardly shifted compared to that for the first quarter of 2022 but the nature of inflation has shifted. Annual energy price inflation has dropped but food price inflation continues to accelerate. As the different shocks reverberate, inflation becomes sticky. Going forward, wage developments should also play a key role. The latest inflation data have caused a jump in the expected terminal rate, which implies a bigger headwind to activity. When inflation surprises to the upside, the likelihood that growth ends up surprising to the downside increases.

In the US, it seems that the expansion phase of the business cycle, the period of elevated inflation, the monetary tightening cycle and the ‘risk-on’ mindset in markets are all far from over. Ongoing relatively strong growth increases the risk that inflation would stop declining. Market commentators have started referring to such an outcome as the ‘no landing’ scenario. However, judging by the latest data, a ‘delayed landing’ seems the more likely one. Markets now expect a higher terminal rate whereby the policy easing would come later as well. The higher the terminal rate, the bigger the likelihood that the landing would be bumpy after all.

In the US, the ratio between the job openings rate and the unemployment rate remains very elevated. It is one sign amongst many of a very tight labour market. As growth slows down, this ratio should decline. Historically, this has been accompanied by slower wage growth. It can be argued that this time, this process may take more time due to labour hoarding, which should limit the increase in layoffs and hence the unemployment rate, and the high level of the vacancy rate, which should underpin the creation of new jobs. This means that there is a genuine risk of disinflation to be slow.

In the US, financial conditions have eased in recent months and weighed on the effectiveness of the Fed’s policy tightening. Jerome Powell recently gave the impression of not being too concerned, so markets rallied, and financial conditions eased further despite the hawkish message from the FOMC. In the Eurozone, another rate hike by the ECB and the commitment to raise rates again in March caused a huge drop in bond yields because markets expect we’re getting closer to the terminal rate. It reflects a concern of not being invested in the right asset class when the guidance of central banks will change: based on past experience, one would expect that bond and equity markets would rally when central banks signal that the tightening cycle is (almost) over. However, as we have seen with the surprisingly strong US labour market report, such positioning comes with the risk of being wrongfooted by the data. What follows is huge volatility.  

Despite the still hawkish messages from the Fed and the ECB, markets are already pricing in rate cuts later this year. What explains these seemingly premature rate cute expectations? They could reflect differences in views on the economic outlook, but it is unlikely these would be so big to justify current market pricing. Another explanation is that investors are rationally managing their risk exposure. Investors know that an unexpected dovish twist in central bank guidance would cause a rally in bond and equity markets. They also know that central banks have no incentive to already soften their guidance but that they have the option to surprise, like they have done in the past. The closer we get to the terminal rate, the bigger the likelihood that central banks would change their message. For investors, waiting to reposition until the announcement is made would be too late. This causes markets to anticipate rate cuts well ahead of time. It reflects an investor attitude marked by the fear of missing out (FOMO), in this case, the fear of missing the rally. It implies that by the time central banks change guidance, markets will already have priced this in. In the meantime, in case of surprisingly strong economic data, rate cut prospects will be repriced and cause an increase in market volatility.

On an annualised basis, US GDP increased 2.9% in the fourth quarter compared to the third. This healthy increase implies only a mild quarterly slowdown. The result was also better than the consensus expectation. However, a detailed analysis shows causes for concern. About half of the increase in GDP reflects inventory rebuilding, although this comes after a negative contribution in the previous two quarters. Personal consumption expenditures have also contributed approximately half of the GDP increase, but investments in structures had a negligible impact and residential investments continue to act as a drag, suffering from high mortgage rates. Moreover, in the final quarter of 2022, GDP only grew 1.0% versus the same quarter of 2021. Despite the apparent resilience in the fourth quarter, the undercurrents are clearly negative, and they should be reinforced by the delayed effects of past rate hikes and the upcoming policy rate increases. Were it not for the strength of the labour market, the talk about recession risk would be even more intense.

The state of the labour market occupies a central role in the analysis of the business cycle. Historically, the percentage of months over the past 12 months with nonfarm payrolls below the 200K threshold increases in the run-up to a recession. Today, this indicator stands at 0 percent. Although there have been many false signals, a significant increase in this percentage calls for vigilance, necessitating closer monitoring of other data as well to assess the risk of recession.  An alternative approach consists of making the link between monthly payrolls and the unemployment rate. However, given the latest data on job creations, a swift increase in the unemployment rate sufficient to trigger a recession signal seems unlikely. This means that the slowdown of wage growth and, more broadly, the decline of core inflation, might take more time than expected, forcing the Federal Reserve to keep policy rates high for longer. This is not exactly what is being priced by financial markets.

Despite the ongoing good pace of job creation and slower wage increases, which through its impact on inflation could influence future Fed policy, there is enough ambiguity in the recent data to fuel the debate on whether the US will end up in recession or not. The survey of professional forecasters points towards heightened recession risk and so do the inversion of the yield curve and the downtrend of the Conference Board’s index of leading economic indicators. If this index were to decline further, one would expect, based on the past relationship, a significant weakening in the monthly payroll numbers whereby the narrative that a recession is around the corner would gather force.

The drop in gas prices, the decline in headline inflation and the improvement of survey data in December have created a feeling that for the Eurozone 2023 might be better than expected hitherto. The survey data bode well for the growth momentum at the turn of the year, which could create a favourable carry-over effect for GDP this year and some hope that lower inflation will mean fewer ECB rate hikes. However, caution is warranted. Inflation remains far too high and core inflation has moved higher in December. Moreover, survey data provide little or no information on the pace of growth beyond the first quarter of this year.

Economic developments in 2023 will to a large degree be the result of the inflation shock of 2022 and the policy reaction of central banks that followed. Three developments look highly likely: disinflation -in terms of headline inflation- should gather momentum, central bank policy rates should reach their cyclical peak and activity should suffer from the rise in interest rates that started last year, implying that the euro area and the US should spend part of the year in recession. The list of uncertainties is long -the evolution of energy prices and the extent and pace of disinflation are key ones- but there are also several factors of resilience, implying that, all in all, the recession should be shallow.

2022 was a year of profound transformation, of shifting geopolitical and economic paradigms. Looking ahead, 2023 should see a change of direction in key economic variables. Headline inflation should decline significantly, central bank rates should reach their cyclical peak and the US and the euro area should spend part of the year in recession. 2023 can be considered as a year of transition, paving the way for more disinflation, gradual rate cuts and a soft recovery in 2024.   

From an economic perspective, 2022 will go down in history as the year in which elevated inflation made a surprising comeback forcing major central banks to start an aggressive tightening cycle. It is highly likely that in twelve months’ time we will look back at 2023 as a recession year, a year of disinflation, and a year in which official interest rates reached their terminal rate and stayed there. As usual, the list of ‘known unknowns’ is long. Energy prices might increase again after their recent decline, disinflation might be slower than expected, policy rates might peak at a higher level than currently priced by markets, and the recession might be deeper and longer than anticipated. However, we should also pay attention to factors of resilience: companies hoarding labour, thereby limiting the rise in unemployment, the support from fiscal policy in many European countries, the need to invest in the context of the energy transition.

Meeting the European Union’s climate-related and digital ambitions will require a huge additional annual investment effort. In the near term, against a background of slowing growth and the prospect of a recession in 2023, this represents a potential source of resilience. In the medium term, this demand impulse may underpin or even increase inflation, in addition to other factors that could lead to greenflation. This would influence the level of official interest rates as well as long-term interest rates. The latter could also be under upward pressure due to the huge additional financing needs compared to the normal financing flows. The financing mix -banks versus capital markets- plays a key role in this respect.

Companies in the US and the euro area continue to struggle to fill vacancies. This will probably make them reluctant to lay off staff when economic conditions worsen, fearing that during the next upturn they would rapidly face new hiring difficulties. By limiting the increase in unemployment, such labour hoarding would be a source of resilience. However, this would be reflected in a decline in labour productivity, which would weigh on profits and could push companies to increase selling prices, thereby slowing the pace of disinflation.

Economic forecasting in the run-up to and during recessions is particularly challenging. An analysis of the Federal Reserve of Philadelphia’s survey of professional forecasters shows that, since 1968, forecast errors during recessions are significantly higher than during non-recession periods. Moreover, forecast errors during recessions are predominantly positive, so forecasts tend to be too optimistic, even if they concern the next quarter. At the current juncture, there is broad consensus, if not unanimity, that downside risks to growth dominate due to the multiple headwinds and uncertainties. The historical forecast record is another reason to be mindful of these risks.   

Since the start of this year, the European Commission’s industry sentiment survey has seen a significant decline, yet companies continue to report that labour remains a key factor limiting production. This is probably due to order books that remain at record high levels in terms of duration of assured production. Through their impact on the growth of employment and wages, labour market bottlenecks should provide some resilience to consumer spending when the economy is turning down. This support will probably not last however. Hiring intentions of companies have started to  decline, which should ease the bottlenecks through a slowdown of employment growth.

Household wealth -the difference between assets (property, financial) and financial liabilities- matters because in the longer run, it should allow to finance expenditures post retirement. During the pandemic, we have seen in the euro area a big jump in the savings rate as well as an above-trend increase in property prices whereas financial assets suffered from negative valuation effects. The European Commission estimates that, on balance, between the onset of the pandemic and the end of 2021, households accumulated around EUR 2.7 trillion of new wealth in excess of the normal trend. This was considered as a factor of resilience for household spending. Households could save less than normal in case of a weaker economic environment because they had saved more than normal during the pandemic. However, according to the European Commission, by mid-2022 elevated inflation had already eroded the real value of additional wealth by almost 50%, implying a much thinner cushion to absorb shocks.

The US consumer price data for October have reinforced the view that disinflation -the narrowing of the gap between observed inflation and the central bank’s inflation target- has started. That conclusion seems clear as far as headline inflation is concerned -it has peaked in June- but we need confirmation that the decline in core inflation from the September peak is not a one-off. Core goods inflation has been moving down but core services inflation  remains stubbornly high on the back of transportation services and shelter. What matters now for the economy and financial markets is the speed of disinflation because this will influence Fed policy, the level of the terminal rate and how long the federal funds rate will stay there. All this influences the perceived downside risks to growth.