The macroeconomic outlook continues to dominate the executive agenda. As demand scrambled and supply chains faltered last year, many companies discovered pricing power they had never experienced before.
But the Fed’s fight against resulting inflation has increased the risk of a recession. Today, macro fears are pivoting away from inflation and towards a further downturn. The notion that a recession would quench the fires of inflation, while compelling, is not guaranteed.
As we wrote here in March, policymakers pose the greatest risk of a US recession. In fighting inflation, they risk depressing growth. If interest rates rise too quickly or too far, they lead to a recession. A “soft landing” is hard.
Since March, that delicate balance has only grown more precarious. The economy, while resilient, is slowing while inflation is likely to have peaked. In the face of this easing pressure, the Federal Reserve’s interest rate path, as priced in by the markets, has become more aggressive. In mid-March, the Fed was expected to hike rates to almost 2% by February 2023; now the expectation is close to 3%. Even if the Fed changes plans, those expectations have pushed long-term interest rates higher. Stock markets, particularly the technology sector, have subsequently suffered sharp falls, putting further pressure on the economy.
Has the policy mistake already been made and is a recession imminent? While we continue to view this as an unlikely scenario in 2022, the odds of a soft landing in 2023 are growing. To understand why, we need to look at the trajectory of inflation and the impact of higher interest rates on the economy.
Inflation has probably peaked
The Covid inflation was an unusual confluence of extremely high demand, fueled by huge stimulus, and simultaneous supply constraints in the product, commodity and labor markets. It was more persistent than was generally expected because new shocks kept coming. First, at the start of the pandemic, it was harmless “bounce” inflation from low prices. Supply bottlenecks came later; then last year’s burst of energy; an enormous scramble for labour; the unexpected war in Ukraine; and the economic lockdown in China this spring. Inflation will remain difficult to predict – those who warned about inflation early on did not because they foresaw the shock effects.
Although it’s not over yet, the time of maximum stress is probably behind us. The demand cools down. Inventories have built up again in a healthy way. Workers return to the labor market. As a result, the inflation figures may weaken as the year progresses.
Another sign of slowing inflation is the dwindling corporate pricing power. Corporate profits rose sharply in 2021 – microeconomic evidence of inflation as companies were clearly able to pass price pressures on to consumers. But that will be less and less permanent. Keep in mind that companies typically face a trade-off between increasing prices and losing market share. When the economy reopened, this compromise was put on hold due to high demand and low supply. But as demand slows and inventories rebuild, pricing power is likely to wane. Big retailers like Walmart and Target recently showed such momentum when they showed shrinking margins.
However, moderating inflation is not the same as overcoming inflation. Realistically, inflation, while falling, will remain above the 2% target rate throughout and plausibly beyond next year – and upside risks remain. There could be new, unexpected shocks.
Monetary policy is getting tough
Although most of the Fed’s rate hikes will occur this year, their delayed impact will push recession risks further into 2023. At current rates, the policy rate will reach a ‘tight’ level of around 3% and headwinds for the economy will persist.
However, this may not be the end of monetary tightening. For monetary policy to declare victory, price growth needs to return to pre-pandemic levels (and the policy target) of around 2%. As inflation drivers turn from idiosyncratic bottlenecks like auto supply chains to more difficult areas like broader services, rates may need to rise further.
The headwind for the economy can already be felt. Expectations of tighter policies have pushed longer-term interest rates higher, hurting equity markets – and thus household wealth and confidence – and slowing spending growth. Significantly higher mortgage interest rates are having an impact on the housing market.
All of this headwind is orchestrated by policymakers without surgical precision. In fact, central bankers are effectively flying blind, only looking at the economy through a blurry rear-view mirror as most macro data lags behind. It’s uncertain how much their decisions will tighten financial conditions or how much that will affect the economy — and all of that could change abruptly. So while rate hikes are a necessity given high price growth, how many and when is virtually unknown.
How soft – or hard – could the landing be?
Since the likelihood of a recession depends on the balance between declining inflation and a slowing economy, we should also ask how much stress the economy can handle.
If a recession is avoided in 2023, it will be because US consumers and businesses are still in robust shape. Household balance sheets are strong and the job market is booming. Encouragingly, we see some moderation in inflationary pressures (such as falling durable goods prices and slowing wage growth) without macro weakness. And while company margins will fall from here, they’re coming down from exceedingly strong levels.
Still, it’s easy to point out the weaknesses of the economy. Deteriorating business sentiment can quickly weigh on investment and sap the economy. And despite the strong labor market and household balance sheets, consumer confidence has been depressed for some time, likely due to energy prices. Add to that the fact that shaky financial markets are shrinking household wealth – a problem that would worsen if the housing market turns around – and the cycle looks fragile.
However, if a recession hits in 2023, there is good reason to expect it to be mild, as the causes of the most damaging types of recessions are less likely today. Banks are well capitalized, profitable and unlikely to drive a structural overhang in a recession. This leaves open the prospect that demand could return quickly and labor markets remain tight, which would keep a recession mild.
Fears of true “stagflation” are premature
One benefit of a recession would be the prospect of quenching the inflationary fire. But what if a recession can’t return price growth to its pre-pandemic slumber? A recession in 2023 or 2024 could easily be accompanied by above-target (2%) inflation, even if current levels are implausible. Such inflation could have had sustained drivers such as wages and housing, in contrast to the idiosyncratic shortages observed so far.
While such a risk would be plausible, such an outcome would not yet represent the true “stagflation” of the 1970s. Although stagflation is popular in the headlines today, it is more than the coexistence of too slow growth and too high inflation. This era was a structurally broken economy in which price growth never settled down because confidence (expectations) in price stability was deeply damaged. This has led to high long-term interest rates, constrained monetary and fiscal policy, and persistently high unemployment rates — a constellation of outcomes far worse than the prospects of elevated inflation and slow growth.
Such a nightmare scenario cannot be ruled out today, but should not be the base case. Standing between a recession with above-target inflation and “stagflation” is the Fed. If the central bank is determined to keep monetary policy tight despite the recession, there is every chance that inflation can be squeezed out of the system. That requires significant strength and independence, as politicians, investors and the public would push for rate cuts. However, given the possibility of a structural break, we still believe the Fed would stand tall.
What leaders should do
To digest the risks, leaders need to focus on four priorities:
First, think strategically about pricing. Although inflation is set to be moderate, it will do so slowly. Risk remains on the upside even in a recession. While the ability to impose price increases will be moderated relative to the Covid recovery, continued price dispersion and volatility will ensure selective opportunities for some games in some markets.
Second, avoid binary framing of the recession and avoid mental models that anchor risk to recent experience. Not all recessions are deep structural scars like 2008, and not all have the severe impact of the Covid recession. Understanding the drivers and nature of the future recession will prepare companies for better navigation. Don’t underestimate the idea that the next recession could be mild and short.
Third, remember that every twist and strain is an opportunity to outperform. Those with a playbook focused on resilience and controlled risk-taking stand a chance of outperforming, relative or even absolute, if they can create and seize strategic opportunities during bad times.
Fourth, while technology stock multiples have fallen sharply, don’t confuse funding squeezes and market corrections with a decrease in the strategic importance of technology. The application of digital technology will continue to drive competitive disruption and growth across all sectors.
In short, while we can be aware of drivers and risks, uncertainty and change require companies to regularly update their view of the economy, prepare for multiple plausible scenarios, and avoid assuming the worst outcomes.
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