Opinion by Roubini EconoTeam on risk of recession in the United States should growth and inflation remain elusive
The base case is that financial stresses will abate soon, implying a fairly benign outlook for the U.S. economy. The Federal Reserve could take a hand shoring up investor confidence; alternatively, investors may see current pricing as an opportunity to buy risky assets, reviving the market without help from the Fed. However, further rounds of risk-shedding would push the U.S. rapidly toward recession. The middle ground, where financial strains remain as they are, isn’t much more appealing, as it brings a moderately high risk of recession.
There has recently been an improvement in economic data relative to Q4 of last year. This mostly seems to reflect a rebound from weakness in Q4. Deterioration in credit conditions is likely to reduce growth prospects for Q2 and Q3, if not beyond. Recent ISM data suggest strains in the factory sector are spreading to the larger services sector.
Last year, the non-factory index fell in reaction to tightening financial-market conditions, but then rebounded. This year, a smaller tightening in financial conditions has led to a larger drop in the non-factory index, with no rebound yet. Repeated financial shocks and the drag from factories seem to be eroding the resilience of the service economy.
Inflation: This Too Shall Pass
Core inflation numbers have recently perked up a bit in the U.S., which has prompted speculation in the press that disinflationary trends are now abating rapidly. A year ago, we noted that residual seasonality has exaggerated inflation readings in the first half of recent years.
We think that pattern is part of the explanation for the recent firming of core inflation numbers. If the pattern plays out again this year, the y/y rise in core CPI should cool to 1.6% in April, down from 2.2% in January. Underlying inflation fundamentals are not strong. Any boost to Treasury yields due to a seasonal rise in core inflation could represent a buying opportunity.
Decisive Fed Action May Be Needed, Could Be Delayed
Increased risks to the economy, a tightening in financial conditions and reduced prospects for inflation over the medium term have led us to lower the profile of our Fed funds rate forecast. We now expect the next rate hike to come in Q2 (rather than Q1), and we will probably push that date back further if financial strains persist. We have also lowered our forecasts for the funds rate at the end of 2017 and 2018. Weakening inflation fundamentals and a further tightening in financial conditions would delay Fed hikes.
If the outlook begins to tilt further downward, decisive action from the Fed (potentially between meetings in extremis) could shore up risk appetite, thus boosting prospects for growth. However, Fed officials may feel themselves to be in a tough spot. Until they reach a decision regarding the workability of negative policy rates, there is little room for rate cuts.
That leaves asset purchases as the main tool for monetary easing, and asset purchases are less powerful than rate changes. Also, even moderate Fed officials may be reluctant to ease when inflation numbers are perking up. In the event that more accommodation is needed, this reluctance could cause an inappropriate delay.