May 2022
 

Vincent Reinhart, Chief Economist and Macro Strategist at Dreyfus and Mellon, outlines the current market backdrop and highlights four indicators which may point toward recession.

Global economic activity is slowing—consequential evidence of the grim double-whammy of the pandemic and the largest European land war—the Russian invasion of Ukraine—since World War II, says Reinhart.

The source of impetus for economic activity—the rebound developed economies had been going through—was a one-off, Reinhart believes, owing to the reopening of marketplaces, fiscal stimulus, and accommodative monetary policy, all amplified by a snapback in global trade.

That was in the second half of 2021 going into 2022. Then the war repercussions hit, including supply/demand imbalances, soaring commodity prices, and China and India’s disparate reaction to Russia’s invasion of Ukraine, for example, and they have cast a shadow over the path of global trade with many developed economies, complicating unity against Russian aggression and changing the dynamics of commodity chains.

And then the unforgiving ghost of years past made its appearance: inflation—which had, in the United States at least, hit its highest level—at 8.5%—in the past 40 years.¹

This, says Reinhart, “has presented the Federal Reserve with an old-school challenge of re-anchoring inflation. Unfortunately, Paul Volcker left the building—and part of his history was engineering a recession to deal with inflation,” which Reinhart sees a probability of occurring by year-end, at 3:8 odds.

But before arriving at a summing up, Reinhart covered various, plausible glide paths of the global economy, none of which are particularly optimistic.

The health situation
“While Covid is still in our future, the pandemic seems to be part of our past,” says Reinhart. However, “people won’t return to complete market activity as long as the health risk remains. And that means that although the disruption to economic activity will lessen, it won’t go away anytime soon.”

Meanwhile the world is beginning to accommodate “pandemic economics,” says Reinhart. “We’re not likely returning to normal, health-wise. Somehow, we must achieve a balance between costly interventions and accepting losses in our less-than-brave new world.”

Yet, Reinhart believes, there’s a worrisome aspect in all this: China. “The world’s largest economy by population size and the second largest in terms of output may have limited natural immunity to the coronavirus because of its zero-Covid policy.”

If China’s stringent measures toward containing the virus continue, say, for the rest of the year, the knock-on effects are a slowing of China’s economy which most likely will have an impeding effect on global economic growth, he adds.

Backdrop for the economic outlook
The world is coping with two “once-in-a-century” events at the same time, and it is not doing so well.

“We’re well past the extraordinary surge associated with discretionary policy stimulus and the openings of markets, but we’re still in a rebound stage, not recovery,” Reinhart says.

One of the key measures he observes is that nominal wage growth in the US hasn’t kept up with purchasing power, which is less that it was just 12 months ago. However, says Reinhart, “the effort to recapture lost purchasing power will add to wages, costs, and inflation.”

Consequently, inflation burst out of the Volcker/Greenspan zone of price stability. “What that means,” Reinhart says, “is that if you ask Fed chairs what the goal of Fed price stability means—they’ll say it’s a state of mind—it’s a situation in which households and businesses don’t need to factor in expectations of changes in the average level of prices.”

But when the Federal Open Market Committee (FOMC) made its forecasts in late 2021, there was a lot of “wishful thinking,” says Reinhart, “that adjusted inflation would close the year at 4.25%” [it closed at 4.7%²], and that inflation would “virtuously fall” to 2.75% by year-end 2023 and 2.25% in 2024.

But, Reinhart says, “the FOMC’s forecast didn’t hang together.”

In March 2022, Fed chair Jay Powell “really thought he made a pivot” to address inflation, by raising rates a quarter point, and announcing that there likely would be further rate hikes. Yet within a week of that guidance, it was out of date, because the “world became more ominous,” Reinhart says, with the brutal ferocity of the war in Ukraine.

Further, one of the problems with inflation is that some prices are “inertial.” For example, in the Consumer Price Index basket, 70% of the prices are “sticky”—think rents, business services, items which don’t change frequently—while the other 30% are more volatile, such as food and energy.

Now the Fed is in a phase of quantitative tightening (QT). However, says Reinhart, “our forecast is that QT will be insufficient to return inflation to the Fed’s preferred goal within the next two years—even though it’s fairly assertive.”

One of the problems the Fed is faced with, says Reinhart, is that in the modern era—that is, since the early 1990s, when the FOMC began to announce policy actions—policy gradualism “set a bad precedent, in our view.”

Policy adjustments, Reinhart says, are asymmetrical—that policy easings typically are larger in size relative to policy tightenings and are accomplished quicker. “Policy rates move up by the escalator, and down by the elevator,” he says.

Particularly now, the US is confronting four leading indicators which point toward a potential recession: the rising fed funds rate, the flattening Treasury yield, spiking energy (oil) prices, and decreasing GDP relative to industrial output.

“When,” for example, “the output gap moves toward zero or even above that, we tend to see economic recession,” Reinhart says. “Why? Trees don’t grow to the sky. There must be some mechanism to slow an economy so that output doesn’t exceed its maximum efficiency capacity by too much. Unfortunately, that mechanism often is a recession.”

Further, as Reinhart points to another indicator as more dour evidence, “It’s not surprising that the slope of the Treasury yield, which builds in anticipation of Fed action, similarly tends to forecast recession—when the yield curve flattens and inverts, recessions tend follow.”

Failure analysis, or reverse engineering
To reach his conclusion, in structural terms, Reinhart says, “we build a decision tree from the bottom up—assuming the outcome at the end. I’ll tell you the result: the economy in recession at the end of the year. No matter what, don’t fight the scenario. Whatever probability you attach to an outcome, think how the world might get there.”

The advantage of failure analysis, Reinhart believes, is that it reduces the dimensionality of the problem, of the probabilities, which has the consequence of pruning the bush of possibilities to each node of the tree leading to the hypothetical event.

“Assume that at the end of the year there’s a recession—this means there was policy failure. Were the politics dysfunctional? Why wasn’t the Fed nimble enough? Why didn’t it pivot effectively to ward off recession? Why was discretionary fiscal policy insufficient?”

Reinhart believes there are many plausible paths to recession in the US in the near term—either because policy is the way it is, or the world becomes worse.

But what also worries Reinhart about the Fed is any pause in combatting inflation in the context of world events affecting policy decisions.

“We believe a case for an extended pause will be compelling and shared by many policymakers—and will most likely be a mistake—which is why we believe inflation will not come back to the Federal Reserve’s goal in 2023 into 2024. We’re going to have to learn to live with inflation. We’re also going to have to learn to live with a major risk on the horizon—and that’s economic recession.”

A summing up
Reinhart believes there are three phenomena that are affecting the global economy: global trade is diminishing, shaking global foundations, especially while Covid still lingers; that inflation and geopolitical risks are increasing; and that firming by central banks is hard on longer-duration assets.

“Right now,” Reinhart says, “there is nowhere to hide.”